In a note to clients, HSBC’s David Bloom argues that the U.S. dollar’s bull run is nearing its end.
There are five main points to the argument. The bolded points are their words, followed by our summaries.
“The cycle is surprisingly EUR-USD bullish” The economic surprise index for the euro area has been significantly outperforming the U.S. economic surprise index in 2015, a reversal of 2014.
“US tolerance for USD strength has its limits” U.S. policymakers may be able to ignore the dollar’s strength if the U.S. economy expands fast enough to generate sufficient internal inflation to offset the disinflation it is importing by virtue of the stronger dollar. This has not been happening, with the Fed’s preferred measure of inflation remaining below target.
“Valuations show the USD is rich” The only currency more overvalued than the U.S. dollar right now is the Swiss franc (see HSBC chart below). Since January 2014, the dollar has moved from No 12 to No. 2 in the rankings.
“USD bullishness has become all pervasive” Positioning for U.S. dollar strength both in the market and in forecasts has become so pervasive it is becoming a constraint on extending the rally.
“The USD weakens in the early months of a Fed hike cycle” This one might sound counterintuitive, but HSBC has looked back over the previous four Fed tightening cycles of the past 30 years and discovered that each time, the U.S. dollar has fallen in the period immediately after the first rate rise.
The call does come with a health warning. There are some tail risks that could give the U.S. dollar another leg higher:
A crash in the Japanese yen as Japan’s policymakers lose control of their currency.
A collapse of the euro on fears of a euro-zone breakup.
A dollar surge on new legislation to force repatriation of overseas earnings to the U.S.
An emerging market foreign exchange crisis triggered by excessive U.S. dollar strength.