US Dollar Rally to Continue as US Economy Booms and "Trade War" Threat Goes Live say Bank of America

-USD rally driven by poor global economic data, not US outperformance.

-But superior US economic conditions can help extend gains for the USD.

-"Trade war" concerns also support USD against all but the Japanese Yen.

© Adobe Stock

The US Dollar can continue to reign supreme over its international rivals during the summer months, according to strategists at Bank of America Merril Lynch, who argue that still-superior levels of economic growth and market jitters over a global "trade war" will help the greenback extend its two-month rally. 

America's Dollar has turned the tables on other developed world currencies since the middle of April, when it sat trading on a 4% 2018 loss against a basket of comparable rivals, as financial markets have rewarded an economy that has gone from strength to strength at a time when momentum is ebbing from the expansion in other parts of the world.

Now, with the US economy remaining in rude health at a time when investors, with their backs against the wall, are increasingly contemplating the implications of an escalating tit-for-tat trade-tariff fight between the US, European Union and China, Bank of America strategists are telling clients the Dollar has further to run.  

"The USD rally since April has been driven more by the rest of the world than by the US. If the market prices the strong US data, the USD can rally further. A trade war would be negative for USDJPY, but we have argued that it would be positive for the USD against most other currencies, including the EUR," says Athanasios Vamvakidis, head of European G10 foreign exchange strategy at Bank of America Merril Lynch.

The US economy grew at an annualised pace of 2.2% in the first quarter, which is down from the 2.9% growth seen at the end of 2017 although more recent data for the second-quarter has had economists suggesting that growth is picking back up again. Some are even forecasting that US GDP growth will be in excess of 4% on an annualised basis for the three months to the end of June. 

"Last year both global and Eurozone data surprised strongly to the upside, while the US data was mixed. It is exactly the opposite so far this year, with global and Eurozone economies losing momentum, while the US is booming. However, the USD reaction to the data this year is a puzzle. The USD should be much stronger, in our view," Vamvakidis adds. 

The Bank of America FX team says the surge in the Dollar index from April came as traders marked down other currencies in response to weak economic data elsewhere in the world rather than as a result of a strong US economy. But that the Dollar can gain a further boost if markets do suddenly take account of an increasingly superior US economic performance.

The greenback could receive an even firmer bid from the market if President Donald Trump remains on the warpath as far as international trade goes. 

"Although the consensus disagrees on whether a trade war will take place and how it could play out, economists agree that uncertainty about trade policy is negative for the economy, and particularly outside the US. Everyone would be worse off in a trade war, but the US likely less so as it is less dependent on international trade and is supported by fiscal stimulus," Vamvakidis writes.

President Trump has  indicated that his administration could follow a series of metals and industrial goods tariffs, aimed mainly at China, with levies on US imports of cars from the European Union and elsewhere in the months ahead. This prompted fears, and much speculation, about a so called trade war in which the US, EU and China impose tit-for-tat tariffs on products imported from other parts of the world. The Bank of America team say this should be good for the Dollar.

"USD returns would likely be highest against the higher beta currencies of economies perceived to be most vulnerable to a slowdown in global and/or US trade, a list traditionally including CAD and AUD among others. Recent sharp deceleration in Euro Area data as a result of rising trade tensions early in the year suggests to us that EUR is also perceived to be included here," Vamvakidis notes.

Although Vamvakidis and the Bank of America team are upbeat in their outlook for the US Dollar, others are calling time on the greenback's rally and forecasting that it will renew earlier declines before the year is out.  

"Recent weeks have seen US equities and the USD rally simultaneously as investors moved funds into the US. We expect these flows to reverse from here, suggesting a lower USD as US markets become less supported. We remain bearish USD largely across the board," writes Hans Redeker, head of FX strategy at Morgan Stanley, in a recent note. 

Redeker and the Morgan Stanley team say President Trump's tax cuts mean the US government will need to borrow more money from citizens and the rest of the world during the years ahead in order to finance a swelling budget deficit. They argue that this will only happen if investors are offered an improved return, which could come either in the form of higher bond yields or a cheaper US Dollar. 

"Given high US leverage, particularly in the corporate sector, higher yields will be more difficult to manage, suggesting a weaker USD is more likely," Redeker explains. Redeker's sentiments are echoed by those on the foreign exchange strategy team at Societe Generale, who also forecast fresh losses for the Dollar in the months ahead.

Societe Generale forecasts the US Dollar index will fall back to 90.3 before the end of 2018, from 95.09 Tuesday, implying a decline of around 5%. Redeker and the Morgan Stanley FX team forecast the US Dollar index will fall even further, back to 89 before the end of 2018, which implies a fall of around 6.3% before year end.

The US Dollar index was quoted 0.33% higher at 94.97 Wednesday and is now up by 2.9% for 2018. The Pound-to-Dollar rate was quoted 0.54% lower at 1.3146 and is down 2.59% this year. The Euro-to-Dollar rate was down 0.46% at 1.1596 and has lost 3.3% in 2018.

Advertisement
Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here