A weaker US dollar reflects a bigger turn in global risk sentiment


Selling pressure on the US dollar is gaining momentum, reflecting a broader global rebound in other currencies, commodity prices and equities beyond Wall Street.

June is picking up from where May finished — a month when the trade-weighted dollar was the worst-performing major asset while growth proxies, led by Brent crude, US-denominated emerging market sovereign bonds and US high-yield debt, led the monthly scoreboard.

Reasons for the dollar’s loss of altitude are varied, but the key driver is a sense that the reopening of virus-hit economies paves the way for a broader recovery in risk sentiment.

Picking up speed are sectors that thrive from a broader economic recovery, such as industrials and materials. These sectors matter a lot more for share markets beyond the S&P 500, with its hefty weighting of technology and healthcare companies.

With a weaker dollar signalling rising risk appetite, global equities outside the US are duly playing catch-up with the S&P 500:

Line chart of Indices rebased (23 Mar=100) showing Global equities closing the gap with the S&P

Mazen Issa at TD Securities thinks US equity leadership “will largely be the case over the medium term”, reflecting its “more diverse, defensive equity breadth”, but the story for now is a broadening in global risk appetite:

“So, as remarkable as this move in risk has been, it is slated to continue as the breadth of the rally has spread to other regional bourses.”

A global rebound and a weaker dollar is also good news for US companies with a global footprint and foreign-based revenues. But having led the rebound, US tech and healthcare are finally ceding some ground as a broader rally gains momentum.

Guilhem Savry at Unigestion argues that a breakout in risky assets beckons through the combination of an improving macro picture, still-cautious investor positioning and asset valuations that are supported by low bond yields.

This will entail a reversal in sentiment that supports “cyclical assets more, such as emerging assets (FX, credit and equities), cyclical commodities and laggards such as the financial sector, small-caps or European equities”.

One question is whether the dollar has room to ease a lot more from here. It’s worth noting that a sharper tone between Washington and Beijing has not stalled US dollar weakness lately, supporting the idea that market sentiment is locked in a recovery trade mindset for perhaps the summer.

The dollar index — weighted heavily by a euro that is near $1.12 — has eased to its lowest level since mid-March, with some traders expecting all of its coronavirus-inspired gains to soon unwind.

Line chart of  showing US dollar weakens as broader risk sentiment recovers

The UK pound is buoyant on talk of a possible Brexit compromise — pushing it back above $1.25 — while several emerging market currencies are extending a bounce that has been running for a couple of weeks.

This is also illustrated by the rally in both the Australian and Canadian dollars, two currencies hit hard when the pandemic erupted. Oil prices approaching $40 a barrel ahead of a meeting by Opec, which is expected to announce an extension of output cuts alongside its allies, is another factor underpinning a rally in several currencies versus the dollar.

George Saravelos at Deutsche Banks says the broad nature of dollar weakness highlights the unwinding of a risk premium that substantially benefited the reserve currency. From here, the dollar will weaken further says George:

“The dollar should be about 10 per cent weaker in narrow trade-weighted terms to fully take out the risk premium, so far we have only moved 3 per cent. We think EUR/USD can rise to $1.15.”

That seems a more reasonable explanation for dollar weakness than other factors being cited such as the wave of civil unrest washing across US cities, let alone concerns over an escalating federal deficit in Washington.

Also weighing on the dollar has been monetary easing, say analysts at Brown Brothers Harriman, a conclusion that should please the Federal Reserve.

As shown below via BBH, the Fed’s balance sheet has increased sharply — by 70 per cent — versus those of the European Central Bank (up 18 per cent) and the Bank of Japan (up 8 per cent) from the end of February:

The BBH analysts add:

“Simply put, the Fed has been much more aggressive with its [quantitative easing] than any of its counterparts. As we saw during the financial crisis, the Fed was similarly aggressive, and the dollar came under pressure in the initial stages of QE. Once other central banks played catch-up, the dollar recovered.”

With the ECB meeting on Wednesday expected to unveil a boost in bond purchases, the reaction in the euro will probably determine whether global risk appetite will run harder or hit a speed bump.

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