A. Can the USD rally last?

• The US Dollar (USD) is in rally mode. It first picked up steam as the 10-year Treasury yield edged towards the psychological level of 3% which it eventually breached. Helped by a lift in short and long-dated US bond yields to fresh multi-year highs while the geopolitical risk perceptions have tentatively waned, the greenback rallied close to 3% since late March.

• As the USD broke out on higher interest rate expectations, lofty bond yields also weighed on equity markets. Major stock indexes struggled to gain footing despite what has generally turned out to be a positive earnings season thus far. They were haunted by the looming ghost of potentially higher inflation and interest rates despite many major index components, most notably in the financial and technology sectors, delivered results significantly better than expectations.

• The move in the USD suggests a major shift in sentiments that could turn out to be short-term supportive for the currency with the potential of turning it into a major event. Weaker than expected data out of Europe and lagging stories from UK and Japan may have faltered a bit on their growth and monetary policy stories.

• With the euro, pound, yen and regional currencies all struggling against a resurgent USD, this trend could continue for a short while. Aside from the continuing focus on rising government bond yields, the Fed’s decision to hold rate in the recent FOMC meeting fell in line with our expectation after the March rate hike, suggesting a total of three rate hikes in 2018, most likely in June and September.

• Still the Fed may likely be on track to deliver four rate hikes this year instead of the three that we targeted early 2018. The fourth rate hike is more likely to happen in December where the probability stands around 40% chance to materialise. Such a likelihood should boost the USD for a while.

B. Question is whether the rally in the greenback will continue, or reverse, in the period ahead?

• The greenback is more likely to continue its rally at least in the near-term. With the bond yields on the rising trend, it has lent support to the USD. Although the USD does not always correlate highly with the US yields, still correlation between them tends to be high when both are rising. The relationship does last for close to about three months. On that note, there are possibilities for this positive USD trend to continue in 2Q2018 with the US bond yields still moving higher and support for a stronger USD.

• However, in the process the greenback is poised to experience some pull back from its upward trend. The reason being, the link between currencies and interest rate divergences reignited when the European Central Bank acknowledged the weaker economic data unveiled of late. But this could easily swing the other way, as expectations are for the euro zone data to improve in the near-term. Besides, it would take just a few words from the US Federal Reserve to reverse this strong USD trend.

• If one trace the behaviour of the USD during the late 2017, the currency saw a decent correction between October and December when the hope for the tax plan drove it higher. However, the greenback rally faded out in the beginning of the year. Issues like the high debt burden and current account position caused discomfort and resulted to a weaker USD at the beginning of the year.

• More recently, the USD bulls focused on the interest rate differentials theme. They comfortably forgot the greenback’s own issues which are high debt burden and current account position that weakened the currency at the beginning of the year. With these problems still there it will be tough for one to ignore it. It means the possibilities for these issues to emerge and weigh on the greenback again in the future is on the cards.

• So, it appears that the behaviour of the USD for now may not be fully supported by the fundamental stories. It could also be supported by “short covering”. The term “short covering” is buying back borrowed securities in order to close an open short position. It refers to the purchase of the exact same security that was initially sold short, since the short-sale process involved borrowing the security and selling it in the market.

• Hence, the current greenback movement may not be fully supported by fundamentals. It will raise eyebrows on whether the greenback will also fade out when we get exhausted with the same old stories that offers limited support for the USD.

• On that note, until the potential incoming data from the major economies starts to unveil more exciting and convincing numbers, the trail of minimum resistance will remain for the market to continue to chase carry and cover USD short remains. The moment potential macro incoming data sheds positive light again, the story of weaker USD will creep again.

C. Euro dollar may not have run out of steam

• Outlook for the euro dollar against the USD may not have run out of steam. The recent weak macro data in Europe has raised some concern on the European Central Bank’s (ECB) plan for a gradual withdrawal of monetary stimulus apart from the potential risk of trade protectionism.

• But the euro economy lost some momentum in 1Q of 2018 partly due to weather and strikes being viewed as temporary. With healthy global growth and supportive trade in euro area, it should support the data to settle and boost confidence. With such perception that the region should start presenting better data in the 2H of the year, it would mean the policymakers are most likely to communicate on whether to end its €2.55 trillion asset purchase even if inflation falls short of their 2% target either in June or July and lesser of September.

• Should inflation remain low, the ECB could consider extending the purchases or have a longer taper. Besides, the ECB has been vocal on their concerns over the stronger currency. Thus, the current €30bil bond-buying programme could be reduced further to €15bil from October and end in December 2018.

D. Softer demand for yen the safe-haven currency

• As for the Japanese, it has been in a consistent state of free-fall for much of April as the widening differential between the US Fed and the expectations of Bank of Japan to maintain its current monetary policy has become increasingly clear.

• A key challenge is that private consumption could be subdued if wage and income growth remains modest. Slow wage growth poses a challenge to policymakers trying to inject further momentum into an economy now in its best run of expansion in 28 years. This probably explains the central bank’s decision to relax the 2% target for the core inflation in the Fiscal Year 2019 that only caused confusion with no major significant market movements.

• Another worry is on the potential threat of US trade protectionism. Trade friction could result to a big blow to exporters who have benefited from solid global demand. Japan’s swelling current account surplus above 2 trillion yen is good for its finances but may not be so for its relationship with the US since it becomes an easier target by the US. Trade surplus with the US is around 631 billion yen in February 2018.

• Meanwhile, the bigger event was the Korean Summit. Here, the leaders of North and South Korea met at the border. They have come to a decision to denuclearize the peninsula and reach a peace treaty. This has reduced the geopolitical tension and has lowered the demand for the safe-haven currency i.e. the yen.

• The risk for the JPY to strengthen against the USD as we go forward cannot be ruled out in view of its safe haven status or growing perception that the BoJ might be nearing the start of its policy normalization, which is likely to happen in 2019. A strong yen could deal a heavy blow to the exporters who have benefited from solid global demand and put a lid on the upside for inflation.

• While we project a weakening USD/JPY in 2018 based on the fundamental factors, we cannot rule out on the possibilities for the JPY to appreciate against the USD in view of negative noises given its safe haven status. However, we envisage the US bond yields rising rather than falling partly due to a tightening monetary policy, which offsets some of the need for the USD to depreciate.

E. Poor run on the British pound may not last

• Poor run on the British pound (GBP) may not last. Recent below expectation figures led to the view that slower economy will continue in the 1H of 2018. But the weak 1Q of 2018 economic growth was partly due to the weather and the GBP took a knock. It could result to the postponement of a rate hike by the central bank of UK in May.

• Though in the near term, volatility is expected to surround the GBP, room for the currency to rebound remains. It will benefit from a better economic performance in 2H of 2018. Retail sales should pick up after being hurt by the bad weather in 1Q2017, while real disposable incomes are starting to rise as inflation subsides (2.5%) and nominal wages grow (2.8%). Labour force participation rate is at 75.4% with house prices becoming stable.

• With the expectation of a pickup in data, the possibility for the next rate hike to be in 2Hof 2018 either August or September should see the pound gain momentum. However, we should not jump into an optimistic outlook that soon on the pound. For GBP to drop further, we need to see a significant spike in UK political uncertainty. At the moment the signals from UK politics and Brexit are vague.

F. MYR still has its upside

• Mixed incoming macro data somewhat contained the slide in the Malaysian Ringgit (MYR) against the USD. Though the MYR is expected to experience volatility along the path, the downside risk remains fairly contained, supported by the macro fundamentals.

• Economic growth will be supported by domestic demand i.e. private consumption while investment remains supportive of the recovery sustained by a buoyant business sentiment, the need to upgrade the capital investment and rising profits.

• The MYR will benefit from the country’s strong linkage in the global supply chain amid robust global export volumes. Expectation of improving public finances, surplus current account, healthy reserves and foreign appetite into the local bourse and bonds space will continue to support the MYR. Onshore sentiments on the local currency has improved.

• Although BNM is expected to maintain the accommodative monetary policy with the aim of supporting growth and stabilising inflation, the possibilities for another rate hike could happen if the demand-pull inflation kicks in strongly and the US Federal Reserve moves into a four rate hike.

• And the undervalued currency based on fundamental analysis as well as real effective exchange rate will provide support to the MYR.

Source: AmInvest Research - 8 May 2018