Why the US dollar rally isn't over

Washington (May 5)  It is arguably the most important question for markets around the world right now: is the historic dollar rally over and done? The short answer: not likely.

After nine straight months of relentless strength against other currencies, the greenback's rally unraveled in April, with the dollar index falling 4 percent, hurt by signs the economy flatlined in the first quarter of 2015

But many pros say the dollar's recent selloff is only a correction in its steady and strong march higher.

"Similar to the FOMC believing the sudden halt to real GDP growth in the U.S. will prove 'transitory' we believe the reversal of dollar appreciation in April will prove unsustainable," writes Bank of Tokyo-Mitsubishi UFJ's FX Strategy team led by Derek Halpenny.

Many drivers behind the great dollar run-up appears intact. The U.S. economy is outperforming other global economies and the Fed is leaning toward tightening policy just as Europe and Japan are doing the reverse – implementing monetary stimulus to fight weak growth. That powerful divergence is why some strategists say the dollar has much further room to run.

"The peak in the last two big dollar cycles in 1985 and 2002 occurred respectively six months and 13 months AFTER the funds rate had peaked AND rates started coming down," writes Alan Ruskin, head of G10 FX Strategy for Deutsche Bank. "This highlights what an aggressive call it would be to suggest the U.S. dollar has peaked even before U.S. rates have started going up!"

Dollar bulls say it will take better economic data in the U.S. to convince the currency market that the Fed is actually preparing to move.

"Confirmation of Q1 GDP weakness being transitory will likely become evident in the data over the coming months, bringing back expectations for the FOMC raising rates in September," Bank of Tokyo Mitsubishi strategists say, predicting the euro will fall below parity against the dollar by the first quarter of 2016 to 0.96.

Optimists already see signs of a rebound in the data. "The second lowest weekly claims figure since the 1970's hammers home the fact that whatever else ails the U.S. economy, the labor market is in good shape," according to Kit Juckes, senior FX strategist at Societe Generale.

Economists are looking for further signs of improvements in Friday's non-farm payrolls report for April, after a disappointing 126 thousand jobs were added in March.

"For the dollar to regain momentum, we need to see a major rebound in job growth," writes Kathy Lien, Managing Director of BK Asset Management.

For the dollar to resume its rally, the market "needs the expectation that monetary policy will normalize. The Fed does not want to give guidance in advance of lift-off because then it will wear the consequences on the dollar, bonds and equities without the pleasure of accomplishing liftoff," says Steven Englander, Global Head of G-10 currency strategy at Citigroup.

"We need to see a string of consistently firm data for the market to gain confidence, but the data do not have to be over-the-top strong to shift investors back to long dollar," Englander says.

And when the Fed eventually does raise interest rates, the dollar will become all the more appealing.

"Even modest Fed tightening say to a terminal rate of 200 basis points will leave the U.S. dollar as a high yielder, probably with the highest short-term yields in G10 outside the New Zealand dollar!" Ruskin writes.

The sharp dollar reversal in April helped shake out some of those betting on the buck, in what had become a very crowded trade. In the latest CFTC weekly data on futures positioning, hedge funds and other large speculators cut their positions to just $35 billion, the smallest since September 2014, according to Scotiabank.

To be sure, there are questions about the health of the U.S. economy and whether it will actually bounce back after the effects of the winter weather and port slowdown subside. Even that, Ruskin says, is no excuse to sell.

"If the U.S. economy is so weak and the Fed never tightens, the global economy is apt to be in such turmoil (with Emerging markets and much of G-10 weaker than the U.S.) to the point where negative global risk appetite will likely support the U.S. dollar.

Source: CNBC