I'll Take the Other Side of the Bet On a Weak Dollar
The U.S. dollar has steadily fallen since 2017. Consensus positioning in the futures market presently leans bearish, and many pundits are calling for sustained dollar weakness.
I’ll take the other side of that bet.
Heading into the second quarter, I think the dollar has several technical and fundamental catalysts working in its favor.
The most obvious technical support for the dollar is the major trendline off the 2011 bottom. That year marked an important inflection in the greenback. Technically, the dollar remains in a bullish trend. Dollar bears will have their work cut out pushing DXY to 85.
The TD Sequential Demark Indicator, shown in the chart below, is another technical positive for the dollar. Red 13s signify when an existing price trend is ripe for a major reversal. This week’s 13 is just the third weekly buy signal for the dollar in the last ten years. The last two instances—in 2011 and 2013—marked excellent entry points. Will history repeat itself?
Several fundamental factors augur well for the dollar going forward.
The dollar’s chief currency competitor is the euro. In the eurozone, economic and inflation data have been weakening as of late, prompting dovish comments from monetary officials. The ECB is still engaging in QE, and markets don’t anticipate the first eurozone rate hike until 2019.
In the U.S., inflation is firmer compared to Europe. Last week, the Federal Reserve increased the fed funds rate for the sixth time since 2015, targeting a range of 1.5 percent to 1.75 percent. Further rate increases are expected later in 2018.
Higher interest rates often attract foreign capital, prompting an upward adjustment in exchange rates. Relative interest rates favoring the dollar should provide a dollar tailwind.
Also, the appointment of Larry Kudlow as Director of the National Economic Council may be another bullish catalyst for the dollar. Throughout his years as a television host on CNBC, Kudlow was a consistent strong dollar advocate. Speaking on air, minutes after his appointment was announced, Kudlow shared an investment tip. “I would buy King Dollar and I would sell gold,” he said.
It is unknown to what extent Kudlow’s views are shared by the Trump Administration. Treasury Secretary Steven Mnuchin has publicly advocated for a weaker dollar, while President Trump has talked out of both sides of his mouth on the issue. At least we know where Kudlow stands, and his appointment should be a feather in the dollar bulls’ cap.
Finally, tax reform should help spur incremental demand for the dollar as firms repatriate money parked overseas. As much as $300 billion could find its way back to U.S. shores in the first half of 2018.
The trajectory of the dollar dovetails with other portfolio themes. For instance, sector and style leadership often take their cues from currency markets.
If my bullish dollar thesis plays out as above, here are a few likely consequences:
Sector winners. Domestically-focused firms tend to perform relatively well during strong dollar periods. That makes financials and utilities likely winners. Firms levered to U.S. consumption also stand to benefit from a stronger dollar.
Sector losers. As we saw in 2014-2015, a strong dollar is bearish for commodities. Hence, firms in the energy and materials sectors tend to underperform during prolonged periods of dollar strength. Multi-national tech and industrial firms could also be vulnerable to negative earnings revisions if the dollar rises in a sustained fashion.
Precious metals. Precious metals like gold and silver normally do not do well in strong dollar environments.
Foreign markets. Foreign diversification tends to be most advantageous when the dollar is weak because domestic investors gain a natural currency tailwind related to their foreign domiciled assets. When the dollar is strong, domestic assets tend to outperform.