Below is a chart of the US Dollar Index, a gauge of US dollar performance against a basket of major world currencies, where the basket contains 57.6 per cent in the euro, 13.6 per cent in the Japanese yen, 11 per cent in sterling, 9.1 per cent in Canadian dollars, 4.1 per cent in the Swedish kroner and 3.6 per cent in the Swiss franc.
Performance of index since 2003
Source: M&G
The dollar index is back to where it was at the beginning of the year, and despite the relative strength of the US economy versus other developed countries, it has now returned to the average level of the last five years.
The reasons that led us – and an increasing number of others – to be so excited about the US dollar over the past 18 months were namely compelling valuations following a decade-long slump, an improving current account balance, the rapid move towards energy independence, and a strengthening US economic recovery where a surging housing market and a steadily falling unemployment rate made it likely that the US would lead most of the world in the monetary policy tightening cycle.
The long-term positives for the US dollar are still there, but have recently been overshadowed by negative ones. So what has changed? Recent US dollar weakness is probably to do with the Fed’s non-tapering in September, the ongoing budget nonsense, and a very big unwind in a whole heap of long USD positions.
It makes sense to be more bullish on the US dollar, because these negative forces appear to be dissipating.
First, the non-tapering event. Treasury yields and the US dollar had already started to drop ahead of the non-tapering decision thanks to a slight weakening in US data, with US 10-year yields dropping from 3 per cent on 5 September to 2.9 per cent on 18 September and the dollar index falling 2 per cent.
Nevertheless, markets were still taken by surprise, and Treasury yields and the US dollar had another leg lower, with US 10-year yields briefly dropping below 2.6 per cent at the end of September and the dollar index falling almost another 2 per cent. But then on Wednesday we had September’s FOMC minutes, which were surprisingly hawkish. The decision not to taper was a close call, where most members still viewed it as appropriate for tapering to start this year and for asset purchases to be finished by the middle of next year.
Yes, the US government shutdown that has occurred since the meeting took place appears to be starting to hit US economic data already, and the weaker data is therefore likely to push the start date for tapering back a little. However, if you assume that the US government shutdown is a one-off event – admittedly not a particularly safe assumption – then the shutdown should merely slightly delay the tapering decision and the normalisation of US monetary policy; it should not result in a permanent postponement.
That said, something that was a little disconcerting from the minutes of the September FOMC meeting was that the jump in mortgage rates played a key role in the decision not to start tapering, with some members worrying that a reduction in asset purchases "might trigger an additional unwarranted tightening of financial conditions".
HSBC’s Kevin Logan makes the good point that higher mortgage rates present Fed policy makers with a dilemma: if rates rise because the markets expect a tapering of QE, and that in turn stops the Fed from tapering, then it makes any QE exit pretty tricky and it appears that the Fed now has an additional criterion for reducing QE – not only must the economy and labour market be doing better, but long-term interest rates cannot rise too much in advance, or even during, the tapering process.
If the Fed’s decision not to taper was heavily influenced by higher mortgage rates, though, then its fears should now be allayed, given the chart below. This chart, together with the effect that mortgage rates have on the US housing market, has clearly taken on added importance.
US Treasury yields vs mortgage rates since 2001
Source: M&G
Does this matter? To finish with a quote from John Maynard Keynes regarding investing: "It is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority. When you find anyone agreeing with you, change your mind. When I can persuade the board of my insurance company to buy a share, that, I am learning from experience, is the right moment for selling it."
Mike Riddell co-manages a number of funds at M&G, including the £1.3bn Global Macro Bond portfolio.
Performance of manager vs peers since Feb 2010
Source: FE Analytics
He has returned 20.97 per cent since he started running IMA portfolios back in February 2010, putting him marginally ahead of his peer group composite.
