Economic weakness and uncertainty abroad have bucked up dollars over the past week and year, a trend that is likely to continue, despite a dovish pivot from Federal Reserve, said strategists at Bank of America Merrill Lynch in a recent note.
“A puzzle in the FX market this year is why the dollar is not weaker. wrote Claudio Piron and Athanasios Vamvakidis, strategists at Bank of America Merrill Lynch, in a note Friday.
“The dollar is overvalued and historically strong, the U.S. economy is slowing, and the Fed as turned dovish. Yet, the dollar is much stronger than a year ago and is broadly flat in trade weighted terms this year,” he said.
Greenback’s biggest rival, the euro
is being weighed down by local economic data, the Japanese yen
has been trading off thanks to a Fed-induced rally in risk assets, and the British pound
is wrestling with the U.K.’s Brexit efforts.
Besides the Fed taking its foot off the dollar-supporting interest rate pedal, market participants also expected to see some weakness in the buck as U.S. fiscal stimulus wanes.
However, the dollar, as measured by the ICE U.S. Dollar Index
has climbed 1.2% versus its rivals in the year so far, according to FactSet data.
Offsetting some of the bearish domestic narrative for the dollar is the grimmer picture outside of the U.S.
Indeed, the European Central Bank on Thursday downgraded its economic growth expectations for 2019 to just 1.1%, compared with 1.7% before. Since the start of the year, the euro has fallen 1.7%, according to FactSet.
The euro-dollar pair “is undervalued by about 7%, but the weak eurozone data keeps the euro from strengthening, in our view,” said Prion and Vamvakidis. The economic woes came on the coattails of political developments in Italy, regulatory changes in Germany and the tumultuous protests in France, they added. On top of that, the eurozone economy is very demand driven and the trade war with China has hurt data in that respect as well.
Meanwhile, Brexit uncertainty is a negative for both the euro and the British pound, as the final result of if and how the U.K. will leave the European Union will have repercussions for both economies.
To be sure, the dollar’s current buoyancy remains fragile, with the possibility that coming data show Europe’s economic picture brightening, pushing the buck lower.
“However, we remain optimistic for reasonable compromises in all these cases, which in turn would also help the eurozone data to stabilize. In this case, the ECB could still hike in December,” said the BofA strategists.
“Better news on the possibility for a comprehensive trade deal between the U.S. and China has also supported risk sentiment and particularly emerging market assets, and has pushed market volatility down. Both the dollar and emerging market FX are doing well because of demand for carry, in our view,” the strategist said.
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