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Is dollar weakness set to reverse?

This year’s dollar weakness took most investors by surprise. There are, however, obvious reasons for this, and fundamentals suggest it could reverse.

“That the dollar had the potential to go further after a bull run of three years was a consensus trade until early 2017, but it then went the other way. Instead, it has now become a consensus view to be bearish on the dollar,” Timothy Graf, head of macro strategy at State Street, told a press briefing in London on Tuesday.

But Graf this radical change of mind by the markets is overdone, because it has led to the dollar exchange rate decoupling from the interest rate differential of the dollar index. “You have to believe the Fed will cut rates, or that the ECB will hike, to justify this,” he said.

Both options look unlikely. Though the ECB will probably start withdrawing its stimulus at some point, the bank is not likely to announce anything dramatic at its next meeting on Thursday.

 

“We’re likely to see a shift away from extreme dovishness in the June meeting- likely through changes to forward guidance, in line with the latest messages from some ECB governing council members. Any detail on tapering is likely to come towards the end of the year – but it will probably be slower than consensus and remain conditional on the strength of the euro,” said Anna Stupnytska, global economist at Fidelity International.

The Trump factor

That leaves one factor that could explain the dollar weakness. Year-to-date, the currency has lost 7.6% against the euro, reversing gains of 5.7% in the last two months of 2016. He would probably take to Twitter to deny this vehemently, but this factor clearly is Donald Trump.

“The new US administration’s tax cut and fiscal spending proposals helped fuel US Dollar demand earlier this year,” Joel Kruger, a currency strategist at LMAX Exchange, told Expert Investor.

“But over the past few months, the government has faced many obstacles forcing the market to reconsider Trump’s ability to deliver on these US Dollar supportive reforms.”

The second factor that sent the dollar up in November and December was of course the Fed, which hiked rates in December and March.

“The dollar has come down because the Trump premium has unwound” admitted Graf. “But the interest rate differential versus the euro, which is now at its highest since 1989, is still there.”

What to expect from the dollar going forward? Read that on the next page.

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