Dollar: Ready For Reversal?

Dollar doesn’t make daring moves. Measured by dollar index, its movement is never magnificent. But the few points fall or rise in the index can mean a lot for emerging market currencies. Its direction is more important than the quantum. Take 2018 for example. In percentage terms, its 4% rally (against narrow basket of developed market currencies) in 2018 was more meagre than meteoric. Yet, it had a ruinous impact on much of emerging market currencies, with some of them falling ferociously by over 20%+. 

As we have seen in the past cycles, it is never a one way traffic. Dollar index is no exception to the dictum that what goes up eventually falls. So, is it due for fall? To understand this, let us go back to what triggered the tide for dollar. As understood well by now, the rally in dollar was rooted in the expectation that strengthening economy will lead to faster pace of tightening by Fed. That was the underlying narrative that kept the dollar in high spirits in 2018. But, financial markets have a funny way of self-correcting itself i.e. the prospect of an event has the potential to change the course of that event itself. In hindsight, one could see that the prospect of fast paced action from Fed had an unintended side effect of pushing US markets into a sizable slump towards the end of 2018, which in turn, has now dimmed the prospects for the prolonged tightening on fears of slowing growth amid market volatility. This whole cycle of self-correction happens all the time in financial market, because of its inherent design to discount all future outcomes in a dashing hurry. It was no different when it came to Fed tightening. The prospect of tightening triggered a spike in 10 year to new high at 3.25% in early Nov, prompting some punters to even project 5% sooner than later. Rising yield amid trade disputes and slowing china, rattled investors by stoking fears of recession. The sharp slump that followed in the US market indices prompted Fed to sound a conciliatory tone with regard to its future hikes. 

With markets now penciling in more pause and less hikes, US ten year too turned to settle much lower at 2.75% level as we write this column.  

How does this development change the track for dollar in 2019? As the recent column in Economist predicts, there could be two scenarios that could be emerging for dollar this year. In either case it is going to be a fall for dollar index. But, against which basket, it is going to fall, will be key to what is in store for emerging markets. First scenario is a rosier one for emerging markets. Here it starts with an assumption that trade war de-escalates giving more headroom for china to initiate tax cuts and loose monetary policy as stimulus to spur private spending. This in turn leads to stronger revival in Europe and emerging markets amid slowing growth in US. On account of this, yields rise in Europe while softening stance from Fed in US keeps the yields there muted. This divergence in yield will lead to dollar weakening against its major currencies in Europe. This will be something similar to what happened in 2016. The year started with the scare of accelerated hikes from Fed, but ended with fewer cuts and prolonged pause which in turn led to surging emerging market flows amid weak dollar index. We may be in for another bout of strong emerging market flows if this scenario plays out. 

The second scenario is more of gloomy one where China’s stimulus (tax cuts and loose monetary) gets stifled by the rising trade tensions leading to soft patch in both Europe and emerging markets. This coupled with slowing US hits the dollar, but this time against Swiss and Yen (as the safe haven), as risk assets sell off across the board. Though probability for second scenario is far less, one can hardly rule that out. 2019 will be an interesting year to watch out for emerging markets based on which scenario plays out!