This text is from blog famous currency strategist Joel Kruger .
NEED TO VENT – There is something that has been bothering me over the past several months and I feel I need to get it off my chest. In recent years, much of the direction in the US Dollar has been somewhat counterintuitive. For the most part, the Greenback has sold off across the board when US data is solid, while rallying when US data is weak. The justification for this type of price action response has been that if US data is good, then it translates into positive risk appetite, which thereby fuels investment in risk correlated assets (not the low yielding US Dollar). Conversely, if US data is on the soft side, the buck tends to find bids and strengthens on the back of a risk off, flight to safety trade. Market participants do not want to be holding risk correlated assets if US data is weak, and turn back to the safe-haven Greenback.
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WHAT ABOUT FIRST IN, FIRST OUT? – While I haven’t exactly been fighting this correlation in recent years, I certainly have become less and less supportive of it. You see…the entire basis for this justification has been on the grounds that if the US is showing signs of recovery, the rest of the world will also be in a good position….and with more attractive yields offered overseas (outside US), it would make sense for the money to flow towards these other currencies. But the reality is nothing even close to this in my opinion. Signs of US recovery should in no way be interpreted as signs of global recovery. The entire global economy has, and is continuing to feel the pain from this latest recession, and to me, the fact that the US was the first in to the crisis, should ultimately see the US economy as the first to emerge from crisis. So what does this mean for the US Dollar?
GLOBAL ECONOMY STILL IN TROUBLE – Well, there are two key USD positive takeaways from this theory which are both USD supportive going forward believe it or not. The first is the fact that market participants should not be so quick to conclude that if US data is good that this translates into a positive for the entire global economy. In my opinion, it is certainly quite possible that the US will start to recover and things will still be bad in the Eurozone, and even worse in China, Australia, New Zealand, and the emerging markets. If this is the case, then you could very well start to see a positive correlation between US economic data and the US Dollar. Stronger US data, in conjunction with ongoing weakness outside the US will be interpreted as bullish US Dollars on the idea that the USD is the only real option given its improving fundamentals and flight to safety status.
ONLY ONE WAY TO GO FROM HERE – The second USD positive takeaway going forward is on the yield differential side of the equation. While it is true that the USD offers no attractive yield advantage at the moment, this also means that there is only one place to go from here. In recent years, yield differentials have widened so aggressively out of the Greenback’s favor that the idea of building a position that looks to capitalize on the virtual certainty of a narrowing in yield differentials back in favor of the buck, is simply too hard to ignore. While the Fed has done a great job keeping monetary policy ultra accommodative, the central bank also recognizes the risks associated with such a strategy and knows full well that the second there are any real signs of sustained recovery, it will need to start to signal a reversal of policy. Remember…it doesn’t matter whether yields are still lower in the US when the Fed signals reversal, it only matters if yields are narrowing back in favor of the buck.
A VERY HEALTHY PROGNOSIS – So in the end, whether it is initially on a flight to safety bid, or eventually on a narrowing in yield differentials, the US Dollar seems better positioned than ever to benefit from global macro dynamics. Sure, currency diversification (away from the buck) is a reality, but the USD will still be the currency of choice for years to come. Sure, there are still some serious structural problems in the US, but the currency game is a game of relativity, and so long as the USD is a more attractive option, investors will be able to brush aside these structural concerns. This will ultimately drive the US Dollar higher over the coming weeks, months and possibly even years.
