Macro Highlights March 09th 2015

Analysis - 3/9/2015

Our Investment Research Department publishes a weekly newsletter with a round-up on the main economic developments and news flow.

The sun never sets on the dollar’s empire

The months go by and the dollar just keeps climbing. After already appreciating 12.8% in 2014 against the other major currencies, it is already up 7.9% more year to date. Although we have been bullish on the greenback for a long time, near term we have recommended caution as asset values never move in only one direction and technical pullbacks are common.

A number of questions about the dollar need to be answered. The most frequent queries at least require an additional explanation. Why is the US currency appreciating? Were we wrong about it? How far can it keep going? Has a run-up this size occurred before? What are the risks of buying dollars today?

Why is the dollar appreciating?

The main reason for the greenback’s gains is the divergence in monetary policy between the US and the rest of the world. Even as the Federal Reserve gradually tightens credit conditions, the other leading central banks continue to ease. This has led to a carry trade in which yield-hungry investors prefer to hold positions in dollar assets, which pay higher interest rates. [...]

Were we wrong about the dollar?

Here the answer is clearly no. We were even among the first to foresee the US currency’s uptrend, in mid- 2013. If anything, we erred by emphasising the theme too soon. But we continue to defend our position and to benefit from it. “Not enough,” the critics will say, since we recently recommended a more reasonable allocation. [...]

How far can the dollar keep climbing?

Two factors are underestimated in our econometric model. The first has to do with the plunge in oil prices. In early November, with crude petroleum trading around $80 a barrel, we did not expect it to keep falling so fast and have such a tremendous impact on US inflation (now in negative territory). According to the theory of purchasing power parity (PPP), the more prices fall in a country the more its currency appreciates. However paradoxical this set-off may seem, it helps keep the prices of goods sold in the country in question near the same level as the same goods sold elsewhere in the world. [...]

The second factor relates to our long-term theme, which is the dichotomy between Fed and ECB monetary policies. Back in January, Mario Draghi officially announced full-blown QE, with plans to buy €60bn worth of bonds every month until inflation closes in on the central bank’s target. The ECB is now printing money like there is no tomorrow. As of November, we had not expected such heavy artillery and, most of all, did not expect Frankfurt to act so soon. And the more euros printed, the more its value depreciates. That which was once true for the Fed and the dollar now applies to the ECB and the single currency. [...]