When will the dollar rise have a break?

Posted on 16. Mar, 2015 by Jean Jacques Ohana in Weekly Focus | 1 comment

The dollar index has been rising more than 10% since the beginning of 2015 and 26% over the last twelve months. The year on year increase of the dollar index has never been so high since the beginning of the 1980’s. According to Riskelia’s Radar perspective, the bubble of the dollar reaches an extreme level of exuberance never seen over the past 20 years.

As a result, monetary effects are so important that they prevail over other financial variables. Since the beginning of the year, the MSCI World is up 0.6% in USD and 16% in EUR, matching the performance of Euro Stoxx 50 in local currency. Therefore, the gain on European stocks is more related to a short position in EUR than the realization of the equity premium in Europe. That is the reason why Global Balanced portfolios strive when they are denominated in EUR (as they have a short euro bias) and struggle when they are denominated in USD (as they have a short dollar bias). By contrast, Riskelia Fund has the same performance in EUR and USD as it captures the actual local risk premiums embedded in equities indices and bonds.

The dollar’s surge poses a threat to emerging countries which have increased their borrowings in dollar over the last five years, thinking that cheap financing and weak dollar would last forever. For instance, Venezuela, Brazil, Russia are undermined by the retreat of commodities and the sharp increase in the dollar. Last but not least, the dollar’s ascent has started to weaken the US economy as reflected by the contrasting dynamics of Economic Surprise Index in Europe and in the US (figure 6). The forecast model of Atlanta Fed, integrating the last economic releases, now anticipates an annualized GDP growth of 0.6% for Q1 2015. This value stands well below the consensus of economists, which was still forecasting a US GDP growth rate significantly above 2%.

As the ECB Quantitative Easing will be presently on auto pilot until at least September 2016, financial repression will remove any yield opportunity in Europe. As showed in figure 8, 8 out of 15 sovereign bonds markets currently display null rates and only the bonds issued by countries whose presence within the Eurozone is politically uncertain (Greece and Cyprus) present yields above 1%. The current divergence between 5 years yields in the US and Germany has never been so strong (figure 9).

The dollar’s surge is testing the nerves of the Federal Reserve. The closer it gets to its full employment objective, the more remote it gets to its inflation target at 2%. As illustrated in figure 10, the US long term forward inflation keeps hovering around historical lows. In the course of the year, the Fed will probably have to step back on monetary tightening in order to stop the dollar’s rise. There will be then some juicy opportunities for US bonds’ holders.

Figure 1: Year on Year rise of the dollar index since 1975.

Figure 2: Riskelia’s bubble indicator on the dollar.

Figure 3: Euro Stoxx 50, MSCI World in EUR and USD since the start of the year.

Figure 4: US dollar credit to non-banks outside the United States broken down by country (Source: Bank For International Settlements – January 2015).

Figure 5: CDS of Brazil, Russia and Venezuela.


Figure 6: Citigroup Economic Surprise index in the US and in Europe.


Figure 7:Atlanta Fed GDPNow GDP forecast for Q1 2015.


Figure 8: 5 years yields on euro zone bonds.


Figure 9: 5 years yields in US and Germany since 1995.


Figure 10: US 5 years / 5 years forward inflation breakeven.


 

One Response to “When will the dollar rise have a break?”

  1. Philip Zavliaris 19 March 2015 at 20:32 #

    Very interesting analysis. Can you give us more insight on how the bubble indicator of us dollar is calculated.