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Dollar exposed to risk of negative surprises

Dubai - Caution towards dollar-linked assets remained underlying theme for Q4 2017

What a year 2017 was for the US dollar. The currency showed new strength compared to its rivals, climbing peaks and crossing valleys. The highs centred around the Federal Reserve's interest rate hikes in the first half of the year. The talk of these major currencies reaching par dwindled in the second half of the year. Weakness reappeared for the dollar when US inflation came in at lower-than-expected levels during the third quarter, sparking market fears.
The caution towards dollar-linked assets remained an underlying theme for the last quarter of the year. The theme was reinforced by the Fed's hesitation over raising interest rates until the last stages of the fourth quarter. In the anxiety left over from the global slowdown and linked economic crises, investors forgot that interest rate hikes are usually tools to check inflation from getting out of control. In the absence of heated inflation rates, an interest rate hike could have the opposite effect. It could limit economic recovery by reducing investment and borrowing.
Instead, investors viewed the lack of further rate hikes through the lens of post-crisis nerves. Seeking reassurance that the economy is still growing, investors reacted with disappointment when the Fed balked and delayed the fourth interest rate hike. The pressure increased for the dollar when the EU economy showed signs of life towards the end of the year. Support for the euro grew as CPI and other data came in at expected levels for November. Although it seems early days yet, the markets started speculating over QE tapering from the ECB.
So much for the year that was. In a yet-to-be charted 2018, what lies ahead for the dollar and those currencies pegged to it like the Saudi riyal? The potential for a weaker performance is there. It can be seen in the possibility that US companies will focus on investor dividends and share repurchases instead of investing in expansion. Or in the US fixed markets performance. They are still not showing any bullish signs. US 10-year yields have been stuck in a range of 2.3-2.43 per cent for the past two months. If we don't see a break to the upside, it's unlikely the dollar will appreciate much further. Most of the good news has been priced into the value of the dollar, meaning that the currency is exposed to the risk of negative surprises. In this scenario, the dollar will stay relatively weak, so the oil price will stay accessible for the foreseeable future. When it comes to US-denominated assets like oil, it will be a buyer's market. Still, an attractive price and exchange rate would likely benefit exporters.
The case for the upside is mainly swayed by the Fed and its economic outlook for the year. If the central bank sees some scope for an interest rate hike in the first quarter, this could reinvigorate the dollar's attraction. The Fed raised its forecast for GDP growth from 2.1 per cent to 2.5 per cent for the full-year 2018. The Fed recently signalled three rate hikes during 2018, and foresees a stable job market. As relatively hawkish stances go, the Fed is sending reassuring messages while hedging its bets because of the Achilles heel of inflation.
The tax breaks are a significant reason for the hawkish stance, but given the losses from the crisis years, it could be that businesses use the extra cash to build reserves or pay out dividends. Risk appetite may still be limited. Playing it safe may be the catch phrase for 2018. Neither fully bullish or fully bearish, 2018 could be the next step up without being the peak for the dollar.
The writer is chief market strategist at FXTM. Views expressed are his own and do not reflect the newspaper's policy.