INVESTMENT INSIGHTS, April 2015

INVESTMENT INSIGHTS, April 2015
In this edition of Secure Wealth Management’s monthly
“Investment Insights” we discuss:
This impressive run has been fairly broad based (instead of
resulting from weakness in just one or two of the other
major currencies), as shown by the fact that the dollar’s
advance/decline line has risen sharply with the tradeweighted index:
Can the US Dollar continue to rally?

We believe that the dollar’s impressive run since
last summer may have seen the majority of its
move, and recently took profits on our long
position in the Wisdom Tree Bloomberg US
Dollar Bullish Fund (USDU).

While we may see some additional upside, the
dollar is starting to see increasingly strong
headwinds. There’s little room for further
devaluation of the yen and the euro, and current
economic data out of the US suggest rate hikes
may be further away than expected.

Taken together with the crowded nature of the
trade, the risks are now tilted towards the
downside. We believe that the recent significant
downward move coming off a multi-year high
may have been a sign of a phase transition, with
consolidation or retracement more likely than
significant further upside.
Figure 2: US Dollar Advance-Decline line, 2005 to present
Source: BCA Research
While falling commodity prices and emerging market
strains have helped, the primary impulse behind the rally
has been the divergence in monetary policies between the
Fed and most other central banks. Indeed, U.S. 2-year swap
rates have increased by over 30 bps since last summer,
whilst the equivalent rates in the other major economies
have been heading in the opposite direction as central
banks outside of the US, notably in Japan and the
Eurozone, have adopted increasingly dovish stances as
they try to stop deflationary forces from gathering steam.
With the US dollar by default becoming a relatively highyielding currency, it is no wonder that the greenback has
soared.
Following its most rapid appreciation since the end of the
Bretton Woods system in 1971, the US dollar index is
currently hovering around its highest levels in over a
decade:
Figure 1: US Dollar Index (.DXY), 2010 to present
However, the rally has stalled of late, and given that being
long the dollar is currently a crowded trade, the natural
Source: Thomson-Reuters
SWM Investment Research
SWM Geneva Office:
7 Chemin des Chalets, 1279 Chavannes de Bogis, Vaud, Switzerland
Tel: +41 22 510 2348
[email protected]
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INVESTMENT INSIGHTS, April 2015
question is whether the dollar can continue its impressive
run against a broad basket of its major peers.
This is in stark contrast to investor sentiment towards the
Euro and the Yen, which together make up a large part of
the trade-weighted index:
While there remains the potential for further upside, we
believe that it is unlikely that the rally can continue at the
same pace, and the crowded nature of the trade means
that the risks of a strong reversal are high enough to tip the
risk-reward balance away from staying long, in particular
against the Euro.
Figure 3: Sentiment towards the euro and the yen, 2006 to
present
Indeed, a variety of technicals suggest that risk of a
pullback are elevated. Net speculative positions (as a % of
open interest) are approaching multi-year highs and bullish
sentiment, at over 80%, is at the kind of levels that will
tempt even the most conservative of contrarians to
consider a short position:
Figure 3: US Dollar net speculative positions (top panel) and
Sentiment (bottom panel), 2005 to present
Source: BCA Research
In short, the overbought nature of the US dollar and the
current sentiment towards the major developed economy
currencies all suggest that the odds of a pullback in the US
dollar index are elevated.
The US dollar is also a long way from cheap, despite the
fact that a cursory examination of the dollar’s real effective
exchange rate (REER), currently slightly below its post-1980
average, suggests otherwise. There are good reasons not
to trust this metric, which does not take into account either
the shift in US trade towards lower-cost locations such as
China and Mexico or the fact that EM productivity growth
Source: BCA Research
SWM Investment Research
SWM Geneva Office:
7 Chemin des Chalets, 1279 Chavannes de Bogis, Vaud, Switzerland
Tel: +41 22 510 2348
[email protected]
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INVESTMENT INSIGHTS, April 2015
has outstripped that of the US over the past quarter of a
century or so. The Fed has created a theoretical exchange
rate to take account of the first issue, and this suggests that
the dollar is currently 7% above its long-term average,
while the productivity growth differentials have likely
shaved around 5% from the fair value of the US REER since
1980. This suggests that far from being undervalued, the
US Dollar is in fact somewhere around 12% overvalued,
which naturally places constraints on how much the
currency can appreciate from here.
inclined to accelerate its QE programme, and Japan’s
current account balance is improving as exports finally
begin to respond to the yen’s sharp devaluation since late
2012.
Rate rises in the US are also unlikely in the near term, given
a stronger dollar inhibits GDP growth in the US, which leads
the market to price out further rate hikes. This in effect
means that there is a critical self-limiting force limiting the
dollar’s upside potential: any significant appreciation of the
dollar from current levels would likely preclude a rate hike
this year and limit the scope for rate increases further out.
Added to this is that is the fact that there doesn’t appear
to be much more room for either the euro or the yen to
devalue further than they already have. The ECB’s
quantative easing should be well discounted by now,
meaning that to keep the euro on a weakening trend
relative to the dollar, either the Fed will need to raise
interest rates in June or the ECB will need to increase the
pace of its asset purchasing programme. As we discuss
below, the former is unlikely to happen, and there also
seems no reason for the ECB to increase the pace of its
bond purchases given the recovery we are seeing in the
eurozone, where economic confidence is hitting new
cyclical highs:
It remains possible that the Fed convinces the market to
take a more hawkish view of coming rate rises – which
would be bullish for the dollar – but the odds currently
favour the Fed’s dots converging with the more moderate
market expectations rather than the other way around.
This is thanks to the disappointing data coming out of late:
growth in Q1 was just 1.9% according to the Atlanta Fed,
core inflation (excluding shelter) has turned negative on a
sox-month basis, and the economic surprise index (which
measures the extent to which a whole host of economic
data exceeds or falls shorts or expectations) is currently
well below zero, as shown in Figure 5 below:
Figure 4: Eurozone Economic Sentiment Indicator, Sept 2009 to
present
Figure 5: Economic Surprise Diffusion Index, 2007 to present
Source: SWM Investment Research
It’s equally hard to see much further yen weakness. BCA’s
PPP model suggests that USD/JPY is currently overvalued
by a rather extreme two standard deviations, and the yen’s
REER backs this up. In addition, the BoJ doesn’t seem
Source: BCA Research
SWM Investment Research
SWM Geneva Office:
7 Chemin des Chalets, 1279 Chavannes de Bogis, Vaud, Switzerland
Tel: +41 22 510 2348
[email protected]
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INVESTMENT INSIGHTS, April 2015
It will be hard for the Fed to raise rates in the current
economic climate. Indeed, Eric Rosengren, president of the
Federal Reserve Bank of Boston, has warned that
deteriorating economic conditions and subdued
inflationary pressures mean that the US economy is still too
weak for the Fed to raise rates. The Fed is split on the issue,
but we expect rate rises to be delayed as the two
conditions set by the Fed for raising rates, namely “further
improvements in the labour market” and being
“reasonably confident” that inflation was heading back
towards the 2% target, have not been met.
Indeed, complacency seems to have set in and the
significant negative outlier for the US dollar on 18th March
(which saw a 2.5 standard deviation move downwards off
a multi-year high, on a day when almost every other major
asset was strongly up) was a warning sign of a possible
phase transition. With the risks increasingly tilted towards
the downside, we heeded this warning and closed our long
position in the WisdomTree Bloomberg US Dollar Bullish
Fund (USDU).
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All this leads us to believe that we are nearing the end of
the dollar rally and we are likely to see a period of
consolidation or retracement for the US dollar. It’s entirely
possible that we may see further modest appreciation:
exchange rates have a habit of overshooting their fair
value, especially in situations where a country
unexpectedly finds itself with higher interest rates than its
trading partners (as argued by Dornbusch in 1976). It’s
entirely possible that we are currently in the overshoot
phase (our REER analysis from earlier suggests this), which
may have some way to run, particularly with the dollar-bloc
commodity currencies and the Chinese renminbi under
pressure. According to Dornbusch, we should eventually
see the dollar depreciate slowly back to its fair value.
However the crowded nature of the dollar trade means
than any reversal could be more severe than the theory
suggests.
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Figure 6: Biggest movers by standard deviation on 18/03/15
Source: FNA Heavy Tails
SWM Investment Research
SWM Geneva Office:
7 Chemin des Chalets, 1279 Chavannes de Bogis, Vaud, Switzerland
Tel: +41 22 510 2348
[email protected]
4
INVESTMENT INSIGHTS, April 2015
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