Markets Overreacted to Mnuchin’s Comments and Now the US Dollar Could Be Set for a Recovery

Markets have overreacted to now-clarified comments by US Treasury secretary Steven Mnuchin and, according to some strategists, a US Dollar rebound could be on the cards for next week.

The US Dollar sank deeper into the red against its international rivals Friday as investors and traders continued to dump the currency, seemingly by the bucket load, but two strategists are now calling time on the greenback’s extreme weakness.

Now knee deep in its fourth straight session of losses, America’s Dollar has fallen precipitously throughout the week even as a rout in bond markets helped push the 10 year US Treasury yield to a four year high Thursday.

The US Dollar index is down 3.67% in January as a result and has fallen by a double digit number over the last 12 months. The Pound Sterling is up more than 5% against the greenback and the Euro up nearly 4%.

Jury members are divided over the question of exactly what is driving the decline although the latest fashion has been to attribute the most recent falls to comments made Wednesday by US Treasury secretary Steven Mnuchin.

“Obviously, a weaker dollar is good for us as it relates to trade and opportunities,” Mnuchin is reported to have said at the World Economic Forum in Davos.

“But again I think longer term the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and will continue to be the primary currency in terms of the reserve currency."

The comments were taken by the market and many observers as signalling a change in the US Treasury’s stance toward the Dollar, with some claiming it might now be deliberately trying to push the greenback lower against its international rivals.

Mnuchin later clarified those comments, while Thursday saw President Donald Trump deliver a riposte to claims the US is trying to manipulate its currency - saying "the Dollar is going to get stronger and stronger. And ultimately, I want to see a strong Dollar."

Nonetheless, the US currency gained only brief respite from the clarification, and then went on to resume its decline Friday.

Above: Pound-to-Dollar rate shown at weekly intervals. It has risen 5.63% in January.

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Friday, strategists at Bank of America Merrill Lynch trod all over the column inches, and market moves, dedicated to Mnuchin’s comments. The FX team at Germany’s Commerzbank is not convinced that it has played a meaningful part in the US Dollar's recent decline either. 

“We think that it is important to understand the context in which the quote was taken,” says Ben Randol, a strategist at BAML.

“Mnuchin was responding to a question pertaining to whether he was concerned about the decline in the dollar since 2017, presumably intended to suggest that dollar weakness is a reflection of the administration and its policies.”

Randol flags that the first part of Mnuchin’s statement has been widely circulated in the media while the latter, and qualifying part, has often been confined to the footnotes of a story.

“Presented with this question, Mnuchin may have initially tried to spin the depreciation positively by responding that "a weaker dollar is good for us," before adding the more relevant language on US fundamentals consistent with his own past statements,” the strategist wrote in a note Friday.

In short, Randol and the BAML FX team say the comments have been misconstrued and that, in fact, there has been no change in the US Treasury’s “strong Dollar” policy.

They argue that the sell off currently underway merely represents a correction of the US Dollar from the overvalued levels it reached in the aftermath of President Donald Trump’s election in November 2016.

Above: EUR/USD rate shown at weekly intervals. It is up 3.64% in January.

US Dollar Rebound on the Cards?

Bank of America's Randol is now warning that a US Dollar rebound could potentially be on the cards, citing internal forecasts that the Federal Reserve will raise interest rates faster than the market gives it credit for this year and a possible reversal of recent Euro strength.

"In our view, corporate flows could be the catalyst that unwinds extreme long EUR positioning and ignites a USD rally. We continue to monitor this potential development closely," Randol writes.

The Fed will announce its latest interest rate decision next Wednesday although current market expectations are for the next US interest rate rise to come in March and for that to be followed by another two moves later this year.

“US finance minister Steven Mnuchin welcomed a weak dollar on Wednesday. This may have strengthened the downward trend in USD, but it had begun much earlier,” chimes Ulrich Leuchtmann, head of G10 FX strategy at Commerzbank.

Leuchtmann has written extensively about the US Dollar’s decline in recent days, arguing that there is no clear fundamental driver behind the move. Instead, it is likely to be factors that remain hidden, or will only become clear some time in the future, that are behind this latest slump.

“We regard wild speculation about these drivers as unprofessional and therefore have to believe that this current USD weakness is transitory and the dollar will recover again,” Leuchtmann concluded in his note Friday.

Many had previously argued the Dollar’s January decline is either the result of another burst of Euro strength, but Leuchtmann flags that the trade weighted Euro index has barely moved in January.

Others say that shifts in central bank foreign exchange reserves may be behind the move, but the merits of this claim will only be understood in time, when data becomes available.

Rising scepticism about the economic benefits of recent US tax reforms or just a downturn in sentiment toward the Washington administration’s handling of the US economy and international relations could also be behind the move, but Leuchtmann is sceptical on this front too.

“The market might suddenly be rating the Trump administration as a huge negative factor for the dollar – inversely to the USD euphoria in November/December 2016. But a fundamental analyst cannot verify or refute such a driver, nor quantify its impact,” he wrote Friday.

In the absence of a clear and identifiable fundamental driver behind the US Dollar’s recent weakness, the team at Commerzbank are standing pat with their forecast that the US Dollar will eventually recover from its current lows.

Commerzbank forecasts the EUR/USD rate will fall back to 1.16 before the end of March and that it will close the year around 1.12, which implies a near-10% for the single currency in 2018.

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