While markets may have been ill prepared for the election of Donald Trump, the early reaction appears to be favorable for USD-based investors. For much of 2016, the U.S. dollar has experienced a period of consolidation on the heels of a more dovish Federal Reserve (Fed) than many expected. However, after breaking through resistance in October, an upward trend in the dollar (and U.S. interest rates) may well be under way. Below, we outline the macroeconomic, technical and seasonal factors we believe may lead to a resumption in U.S. dollar appreciation heading into 2017.
As election results rolled in on the night of November 8, it seemed like markets were bracing for a repeat of Brexit, i.e., when the United Kingdom voted to leave the European Union. However, with the exception of some emerging markets, risky assets appear to have shrugged off the more divisive elements of Trump’s rhetoric and viewed his policies with an open mind. While more concrete plans will be forthcoming, it remains essential that Republicans learn from the mistakes made by Democrats in 2008 and not overstep their mandate.
In general, an oft-cited driver of asset class performance this year has been the market’s recalibration to the likely pace and timing of a change in U.S. monetary policy. During the first half of the year, interest rates around the world declined, defensive equities outperformed cyclicals, and the U.S. dollar generally fell against a basket1 of foreign currencies. Since July 8, rates were rising as the market grew increasingly comfortable with the prospect of a Fed rate hike at its December 14 meeting. Since November 8, longer-term interest rates have risen dramatically, fueling the strength of the U.S. dollar.
In light of the perceived divergence in the path of policy, virtually all foreign currencies have depreciated against the U.S. dollar. Additionally, while many emerging market (EM) currencies have rallied in 2016, several major EM central banks may be poised to cut rates in 2017.2 And while many EM currencies remain well below their five-year averages, this divergence in central bank policies will need to be closely monitored.
As many investors can attest, the success of a tactical shift in allocation often boils down to timing. To help make this determination, investors often look to the market’s technical positioning. As illustrated below, after retesting previous highs set in August, it seems like the dollar has finally broken through. In much of our work on currency markets, our favored technical indicator compares the 10-day against the 240-day moving average. On October 20, the 10-day crossed above the 240-day, signaling a potential shift in trend. Additionally, on the back of Trump’s victory, the dollar blew through both the 50% and 61.8% Fibonacci retracement, two other widely watched technical levels.
Bloomberg Dollar Spot Index (BBDXY)
Finally, we previously highlighted that “sell in May” does not necessarily apply to the U.S. dollar. In a similar analysis, it appears that November also exhibits a strong seasonal track record for U.S. dollar strength. While we are currently struggling to identify the primary catalysts of this phenomenon, it seems that the Japanese yen as well as many emerging market currencies have tended to depreciate against the U.S. dollar in November. Regardless, positive seasonal momentum combined with fundamental and technical strength could help corroborate a resumption of the trend in the dollar.
In sum, investors should consider what impact a resurgence in U.S. dollar strength may have on their portfolios. In our view, the intersection of global macro, technical positioning, political and seasonal factors may support broad-based appreciation of the U.S. dollar in the coming months.
1As proxied by the Bloomberg Dollar Spot Index.
2Source: Bloomberg. As of 10/31/16, Mexico is the only major EM central bank forecast to hike rates in 2017.
Important Risks Related to this ArticleInvestments in currency involve additional special risks, such as credit risk and interest rate fluctuations.