UBS: Dollar on the move - Implications for investors

We believe that recent better US economic data actually warrants a stronger dollar in the coming months, as the US Federal Reserve raises interest rates. Nonfarm payroll growth of 215,000 in February surpassed expectations. Wages have been rising above 2% over the prior year. And stabilizing manufacturing and non-manufacturing ISM data (including the services’ employment gauge moving back into expansionary territory) implies further labor market tightening.

Rising pay demands are pushing US core inflation closer to the Fed’s 2% target. February’s 1.7% year-onyear gain in the core personal consumption expenditure (PCE) price index was the highest since January 2013. That should eventually justify a less dovish tone from the Federal Open Market Committee (FOMC), and a market re-pricing of the path for the fed funds rate. 

Futures are pricing in between zero and one rate hike this year. We expect two second-half rate increases, and a stronger US dollar as markets reset for tighter US monetary policy relative to other major central banks.

A stronger greenback could reverse the recent rallies in commodities and certain emerging market (EM) currencies. First-quarter performance data for oil suggests the recent price bounce was chiefly driven by dollar weakness. Brent crude oil climbed 6% when measured in dollars, yet prices fell 2% for major producer Russia in ruble terms.

We don’t advise holding commodities in global portfolios, and expect oversupply (especially in oil markets) to clear only in the second half of the year. Conversely, a brighter US growth and inflation outlook, in conjunction with an expected resumption in US profit growth in the second half of the year, supports our tactical US equity overweight versus high grade bonds.

Longer term, the path of the dollar may depend more on the actions of other major central banks, and how successful they are in achieving policy objectives. A combination of tepid growth and sub-par inflation will likely lead Asian central banks to loosen monetary settings, and we expect EM Asian currencies to depreciate on average by 4–6% against the USD over 12 months.

Ongoing monetary and fiscal support in Japan should weaken the yen from 18-month highs, so we are maintaining our long USD versus short JPY position in global tactical asset allocations. Against the euro, though, we think the dollar could lose ground over the next 12 months. As the European Central Bank (ECB) easing in March feeds through into more robust activity and a firming in Eurozone inflation, talk may turn toward ECB policy normalization. We expect the single currency to rise toward 1.16 against the USD in 12 months’ time, but for it to do so a period of stronger US growth that supports the global recovery and less-divergent monetary policies is necessary, in our view.

We believe the greenback should strengthen in the coming months as markets re-price for higher inflation and more Fed rate hikes. US economic improvement and a pick-up in second-half earnings growth should support our tactical US equity overweight in global asset allocations. But a dollar rally could leave USD-sensitive commodities vulnerable to setbacks. On a 12-month time horizon, the US dollar may weaken against the EUR.

Author: Matthew Carter, UBS Global Investment Office

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