The US dollar continues to rally on the economy and risk aversion, but can it continue?


Global growth has become of significant concern to market participants over the past few months, resulting in a decline in risk appetite. With Europe underperforming, global trade tensions growing, and rates pushing borrowing costs to levels not seen in many years, money has been flowing out of Europe and EM, and into the US, pushing the dollar higher. This has occurred in part as the USD is seen as a safe haven in uncertain times, and in part because the US economy is performing well, attracting investment into the country.

 

US economy continues to outperform

 

The US economy has been outperforming market expectations since late last year, whereas Europe’s biggest economy has done the opposite.  The Citigroup Economic Surprise Index, which tracks how expectations are being met by data releases, shows that the US data is broadly meeting or exceeding expectations, while the Eurozone index dropped to its lowest level since September 2011.

 

 

 

 

The UK has similarly underperformed market expectations. 

 

Looking at a more global perspective, we’ve seen a marked decline in fortunes for EM space, as the USD strengthens, and along with higher rates translates into tighter liquidity conditions for EM assets. Add to that the surge in oil prices since the beginning of the year, which is a major import cost factor for many EM countries, and it’s tough for EM economies to entice new investment flow any time soon.

 

Investors shift focus to the US

 

For the past decade, investors have put more money into foreign equity funds than into US equity funds, at a ratio of around 2 to 1, according to Morningstar data.  However, in the first three weeks of May, investment into US funds outpaced global funds by 25%.  With the prospects of economic growth and associated market gains now looking better in the US than elsewhere, this trend looks set to continue.

 

Risk aversion continues to grow, despite Trump’s on-again, off-again meeting with North Korea

 

The US dollar, as a safe haven currency, is a good measure of the market’s risk aversion. After cancelling the meeting with North Korea last week, Trump has now tweeted that the “[US] team has arrived in North Korea to make arrangements for e Summit between Kim Jung-Un and myself”.  One would think this announcement would have been risk-reducing, as fears of tensions in the Asian region will clearly subside if North Korea is to de-nuclearize. Despite this latest tweet,  the USD rallied since Friday’s close.  The likely explanation is that Trump could change his mind once again.  As well, over the weekend, the Italian political situation turned south, with Italy set to be heading to the polls, possibly as early as the fall.  More uncertainty in Europe continues to weigh on the single currency, with the EURUSD hitting a new 2018 low at 1.1608. 

 

2-Day EURUSD Chart

 

 

 

What does this mean for FX?

 

Until we see the relative performance of the US economy stumble with respect to the rest of its major trading partners, and we see investors increase their risk appetite, the general trend will remain for a strengthening USD.  However, FX tends not to move in a straight line, and corrections can be deeper than markets expect once they take hold.  With the USD looking fairly over-bought at present (as indicated by the Relative Strength Index (RSI) on the chart below), I would not be surprised to see a decent correction coming soon.

 

EURUSD Spot and RSI Chart

 

 

Source: Bloomberg

 

 

Author: John Glover



 

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