Market Insider

Dollar could follow its worst performance in 14 years with another weak year

Key Points
  • After its worst performance in 14 years, some strategists see more declines ahead for the dollar.
  • With the Fed raising interest rates and an oncoming gusher of fiscal stimulus from tax cuts, it would make sense that the dollar would rise.
  • But the greenback is competing for capital flows in an era of synchronized global growth. It could continue to lose out to the euro, which is up more than 14 percent.
How to play a weak dollar in 2018: Pro
How to play a weak dollar in 2018: Pro

After its worst performance in 14 years, it would make sense that the beaten-down dollar should rebound next year, especially with the Fed raising interest rates and an oncoming gusher of fiscal stimulus from tax cuts.

But some strategists instead see the dollar continuing its decline, which started in the early days of 2017, as it competes with other currencies in a period of synchronized global growth.

"We have a negative bias on the dollar, which is extraordinary considering that interest rates are going to rise at a very good clip," said Jens Nordvig, CEO of Exante Data. "It got too strong before January, and the other factor is that global growth is very strong."

Stoyan Nenov | Reuters

President Donald Trump favors a weaker dollar and he has said as much, comments that added to negative sentiment on the greenback early in the year, according to Nordvig. U.S. exports are much more competitive in a world with a weaker dollar.

"I think for next year, the big question is, is this tax reform going to be able to provide any support or not?" Nordvig said. Corporate taxes were cut to 21 percent from 35 percent, and individual rates were also sliced for most Americans.

What could change the course for the dollar is if the Federal Reserve ratchets up its forecast for interest rate increases. The central bank currently expects to hike three times, but some Wall Street economists are now expecting four because of the tax cuts and improved growth. They say the Fed could revise its forecast after its March meeting.

"If they at some time start to think that is not enough, that would be a very hawkish signal that would take the dollar up. The problem is even if we have this good news, and people are getting excited about tax reform, inflation is not there," he said. "If inflation numbers don't come through in coming months, it's not a slam dunk they hike in March."

Citigroup currency strategists said they were also expecting a negative move in the U.S. dollar next year, and they forecast a 5 percent decline against developed country currencies in the next six months to a year, but less against emerging markets.

The Citi strategists said drivers for the dollar are the fact that global growth is now converging in the U.S., Europe, Japan and emerging markets, instead of diverging. They also see more upside for the euro as the European Central Bank continues to be more accomodative than the Federal Reserve, and they note a longer-term trend of deterioration in the U.S. net international asset position over the past 10 years.

The dollar index, which represents a basket of currencies dominated by the euro, has dropped 9.9 percent this year, its worst performance since 2003. The euro, trading at $1.20, has gained about 14 percent for the year — its best performance in 14 years.

"The euro zone is growing at the same pace," Nordvig said. "Clearly, the euro got to a very low level, and it's recovering, and I think there's a lot of people who have been surprised by this euro strength. So they're in the process of getting back to benchmark and changing their hedges."

Nordvig said big investors, like insurance companies, are unwinding long dollar positions they added in 2014, when Europe and other sovereigns were going to negative rates. That unwind continues, but it could be coming nearer to an end, he said.

But Robert Sinche, chief global strategist at Amherst Pierpont, said he expects the dollar to reverse course and gain 5 to 8 percent against a group of currencies in 2018. He writes off some of the recent decline to seasonal weakness at this time of year, based on reduced capital flows.

"The euro was up 14.1 pct since the end of last year. Over a five-year period, the euro is down 9 percent. It's kind of like, 'is the dollar strong? or is the dollar weak?' It depends where you start," he said.

Sinche said he expects higher rates to be a catalyst for the dollar, and he expects to see global bond yields rise.

"People who are complacent on the bond market are forgetting about that by October, the ECB is out of the asset purchase business. The Fed balance sheet reduction accelerates each quarter and becomes meaningful by the end of the next year," he said. "I think we could have a much different supply demand backdrop by the end of 2018, and I think one of the surprises will be that bond yields around the world will move up more than people think."

Some investors have been watching for an impact on the dollar from U.S. companies repatriating billions in overseas profits, which is required by the tax law changes that take affect Jan. 1. But Nordvig said his firm found it will not have a major influence.

The dollar could be hurt by capital flows into Europe or China. Nordvig said he expects to see continued flows into China as investors move into Chinese markets. "These markets that had been closed to foreigners have been opened up," he said. "They are picking up and that's something that has more potential to be something in 2018. The Chinese officials recognize this. They want them to open up."

Another risk for the dollar is the potential for a trade skirmish between the U.S. and other countries. Nordvig said he sees a He said it's possible the U.S. could also have a trade dispute with other countries.

If NAFTA falls apart, "The country that's going to be hurt is Mexico, but I don't think it's going to help the United States, so it could strengthen the euro and it could strengthen the yen," he said. "Europe just did a trade deal with Japan in record time. Europe is going to do a free trade agreement with Brazil. They're going to do one with Mexico as well. ... It could be the strengthening of the other kind of reserve currencies — the euro and the yen."

WATCH: Dollar bulls have a long wait

Santelli Exchange: Dollar bulls have a long wait
Santelli Exchange: Dollar bulls have a long wait