For most global investors, U.S. dollar hedging was the only currency risk management strategy to follow in 2018.
The dollar rose against all of its major developed market crosses -- by 3.4 percent vs. the euro; 4.5 percent vs. Canadian dollar; 5.1 percent vs. pound sterling; 5.8 percent vs. Australian dollar; and a more modest 0.3 percent vs. the yen.
Dollar strength against the supposed darlings of the emerging markets -- the BRICs (Brazil, Russia, India and China) -- was even more marked. The Brazilian real declined 15.1 percent against the USD, the Russian rouble 11.8 percent, Indian rupee 10.4 percent and the yuan by 4.2 percent. Long dollar was more than a good hedge, against a backdrop of generally declining asset prices it was among the trades of the year.
The USD also burnished its credentials as a safe haven. When the S&P 500 peaked on Sept. 21, the trade-weighted dollar index stood at 94.22. Following an 18 percent fall in equities, the DXY ended the year at 96.11. Rising volatility has, so far, been USD positive. In short, 2018 was an annus mirabilis for the dollar.
Behind the Dollar Rise
A variety of factors have powered the dollar rally, but the most significant of all has been strong U.S. growth. This has enabled the Federal Reserve to continue tightening, which in turn widened interest-rate differentials with the rest of the world. Positive carry in the most liquid reserve currency has been irresistible for investors. The December Commitment of Traders report recorded an 85.2 percent (non-commercial) long position in U.S. equity index futures.
Positive U.S. growth looks set to continue into 2019. However, the pace is already slowing. The second quarter was the high-water mark for growth momentum as U.S. tax cuts powered earnings and capital expenditure. Those tax reforms also encouraged companies to repatriate foreign earnings which gave a further boost to the dollar.
The Twin Deficits
Those tailwinds have all but blown out. In 2019 attention is likely to turn to the ballooning U.S. budget and current account deficits. The lessons from history are somewhat mixed, however. Supply side reforms and stimulus began a long period of economic expansion in 1982 which was accompanied by significant dollar strength.
Actions from an inflation-fighting Federal Reserve were crucial. Throughout the 1982-1985 period, interest rates were in a range between 7.75 and 15 percent while inflation averaged just 3.8 percent. Real interest rates were at unprecedented levels. That was the focus of the market and it helped drive the dollar inexorably higher until the Plaza Accord was signed September 1985.
In most other periods a rising current account deficit has weakened the dollar. Foreign investors have demanded a greater risk premium for funding U.S. dollar liabilities. If U.S. growth slows or global growth converges with the U.S., the twin deficit will come back into focus.
Intriguingly, ever since current Fed chairman Jay Powell commented on Oct. 3 that U.S. interest rates are a "long way from neutral," two-year inflation break-evens have collapsed from 1.84 to 0.68 percent. On the one hand this is good news for real interest rates, but it also indicates investors are wary of a deflationary bust.
Futures tell a similar story. In November they indicated a 90 percent probability interest rates would end 2019 higher. By mid-January they were pricing a 97 percent probability that the fed funds rate will remain unchanged or be below its current level. This also suggests investors believe the Fed's growth forecasts need to be revised downward.
2019 Dollar Headwinds
Additional headwinds for the U.S. dollar in 2019 are valuations and positioning. On a real effective exchange rate basis, the dollar is 10 percent overvalued relative to its history. The Swiss franc is also overvalued, but the other traditional currency safe haven, the Japanese yen, is significantly undervalued.
Rising trade tensions between the U.S. and China weighed on the yen in 2018, but regardless of how this impasse is concluded, selling USDJPY arguably makes sense based on fundamentals especially if the U.S. economy slows. Long dollar is also a crowded trade, which may make investors wary about extending long positions.
We may have already seen a taste of that in early trading sessions in 2019. On Jan. 3 negative forward guidance from Apple was the catalyst for a big move in Asian currencies. At one point the yen appreciated by 3.7 percent vs. the USD. The Australian dollar slumped to its lowest level against the dollar in a decade. In 2019, it seems investors are reassessing currency safe havens.
(This article is sponsored and produced by CME Group, which is solely responsible for its content.)