A little over three weeks ago, Goldman had a simple message for clients: “about those ‘top’ long dollar trades… yeah, fuck it.”
Of course they didn’t put it that way. This was the headline:
As we noted at the time, there’s a long history behind that reco and it’s funny, but the larger point was that the move to “close” the trades came on the heels of an abysmal quarter for what, going into 2017, was the consensus trade.
Between Trump jawboning and doubts about the viability of the reflation narrative in general, the “sure thing” long USD trade turned out to be anything but.
[To be fair, the trades in question were a little more specific. They were: long USD versus EUR and GBP, and long USD/CNY via the 12-month NDFs]
Well on Wednesday afternoon, the very same Zach Pandl is back and now he and Silvia Ardagna are “dialing down [their] dollar forecasts” against G-10 crosses, which is amusing because it kinda, sorta seemed like the greenback was just getting some momentum.
Ultimately, Goldman isn’t saying it’s all downhill from here, but then again, they kinda are. Arguments and counterarguments presented below.
In the roughly 45 years of mostly floating exchange rates and increasingly mobile global capital, the US dollar has gone through three periods of broad-based appreciation: (1) a 45% cumulative gain in the real effective exchange rate (REER) from late-1980 through early-1985, fueled by Reagan-era fiscal expansion and the Volcker Fed’s efforts to tame inflation; (2) a 34% surge from mid-1995 to early-2002 during and just after the dot-com years; and (3) the most recent, which we would mark from July 2014 and which has featured an 18% cumulative appreciation in the REER to date (Exhibit 1). We now see this latest dollar bull run as moving into its latter stages and are downgrading our forecasts for the greenback against G10 crosses. Investors with significant dollar length should consider a more neutral stance.
Although we are taking down our forecasts, we are not quite ready to call the dollar trend over, as several factors supporting appreciation over the last three years remain in place. First, the US economy looks close to (and perhaps slightly beyond) full employment, which should keep the Fed marching ahead with rate hikes.
Second, fiscal expansion should support growth despite a maturing business cycle. Admittedly, the slow start by the Trump Administration on its policy agenda has led us to push back the expected timing of tax cuts and (modest) spending increases to 2018. But we think that investors may now have turned too pessimistic on the prospect for tax cuts, which are likely much easier to move through Congress than issues like health care reform.
Third, given this economic backdrop, expectations for the federal funds rate priced into the bond market look too low. A rate increase by the FOMC at its June 13-14 meeting appears very likely—our economists now see a 90% chance of a hike. After June, market pricing implies that it will take until the end of 2018 for the FOMC to deliver two more hikes, bringing the funds rate to about 1.65% (Exhibit 4, left panel). In our view this is not a balanced assessment of the outlook for US policy rates. Recession risks still look relatively low, and policy reversals are quite rare—so the probability of rate cuts should be considered very low. In contrast, we would not rule out as many as 5-6 additional rate hikes over this same horizon (or at least an intention to hike that many times, which may also have implications for the exchange rate).
Despite these positives, a number of fundamentals have changed, such that we now see more limited room for broad dollar appreciation. First, the dollar is moderately overvalued across a range of standard metrics—8.5% according to our GSDEER model, and by similar amounts using Purchasing Power Parity (PPP; Exhibit 5).
Second, global growth has picked up, reducing the degree of US outperformance. According to our Current Activity Indicator (CAI) system, growth in developed market economies has accelerated to 3.1% in the three months ending in April from about 1.7% in mid-2016; growth in emerging market economies has picked up to 5.4% from 4.3% over time same period (Exhibit 6)
Third, the scope for monetary policy divergence—the dominant factor behind broad-based dollar appreciation over the last three years—is much smaller than in the past. As noted above, we do expect a modest “divergence resurgence” over the near term as the market prices a few more rate hikes from the Fed. But the forces that drove outsized dollar appreciation in the past are unlikely to be repeated.
In short, the US outlook is still reasonably bright, but conditions abroad have improved more on the margin and may continue to do so. As a result, the distribution of risks around the dollar outlook now appears more balanced.