USD gained 1.78% versus the G10 average in Q4.The quarter began on a strong footing, with October accounting for nearly all the gains for the three-month period. The themes of US exceptionalism, stronger US growth and higher yields relative to the rest of the world returned in earnest during October as US Federal Reserve (Fed) Chair Jerome Powell commented that US rates may move above neutral levels. Markets responded with surprise to both Chair Powell’s remarks and the hawkish mid-month Fed minutes, pushing USD higher. October’s economic data reports also helped support USD and validated the Fed’s hawkish stance. Early in the month, we received strong Purchasing Managers’ Index (PMI) reports, factory orders and durable goods data. Additional gains in October were prompted by consistently poor performance in global equities and rising risk aversion. USD has often benefited from weakness in equity markets as it tends to attract safehaven flows. USD moved sideways for the remainder of the quarter. In November, congressional elections, some more mixed messages from the new Fed Vice Chair, Richard Clarida, and ongoing worry over the US-China trade dispute caused volatility, but no significant move in either direction. In December, the sideways move continued, with a slightly disappointing employment report and lower Fed policy projections offsetting positive support from increased global risk aversion.
The reduced carry, aka convergence, in yields that took centre stage in December has been a key theme watched by USD bears. They believe that as US rates reach their cycle highs and the yields of other countries catch up to close the gap, USD should suffer. The problem is that if the rate convergence happens in a falling rate environment due to expectations of a broad global downturn, we would expect that rate convergence to accompany a flat to higher USD rather than a lower USD. This is exactly what happened in December. USD rose steadily from 4 December through 24 December. Rising risk aversion and the resultant USD inflows overpowered the trend lower in yields and the Fed’s reduced rate forecasts. In fact, if it were not for the sharp post-Christmas equity rally and coincident USD sell-off into month end, USD would have finished up nearly 1.8% versus the G10. Going forward, we expect USD to continue to move sideways to slightly higher for as long as recessionary fears and high risk aversion dominate. During this period, we expect the currency to be more sensitive to economic data as investors search for signs that the US is slowing more rapidly than the rest of the world. On the topic of relative US growth, we are sceptical that the widespread fear of a recession in 2019 will materialise. US growth and employment numbers remain strong and will likely show more stability than recent rates and equity-market price action suggests. In comparison, the rest of the world is more challenged and should continue to slow down at least as much as the US, if not more. One thing that may help the global growth outlook and weigh a little on USD is a resolution to the US-China trade dispute. It’s far too early to forecast success in those trade negotiations. The best we can hope for in the near term is that progress is made by early February to further extend the 90-day truce. This extension seems increasingly likely because weaker equity markets and slowing growth raise incentives for Presidents Trump and Xi to find a satisfactory resolution.
Overall, lower US yields, weaker US equities and moderate slowing in economic activity are enough to reduce our tactical USD outlook to neutral with a slight positive bias. These factors are not compelling enough to justify a short USD position as absolute interest rates, growth and inflation in the US are still materially better than most other countries and USD should continue to benefit from ongoing bouts of global risk aversion. In the longer term, USD remains overvalued relative to our longrun estimates of fair value and we suggest a short USD position or reduced foreign hedges for US investors.
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