Dollar Doom and Gloom Looks Overdone

By Anjani Trivedi

The U.S. dollar’s performance has been anti-climactic this year, dropping 4% against a basket of major currencies. But investor pessimism may have gone too far.

Of course, there is still good reason to root for other currencies. The Trump administration’s lack of policy mojo aside, global economic data has proven unexpectedly robust, posting the longest run of positive surprises in six years. But as investors cheer a reflating global economy, they may be dumping too many dollars: For the first time in more than a year, U.S. dollar positioning, according to data from the Commodity Futures Trading Commission, has flipped from net long to net short.

Excessive pessimism about the dollar creates its own worry for emerging markets due to the danger of sudden swings back. During the past few years of low U.S. interest rates, governments and companies in developing countries have gotten used to borrowing heavily in dollars. Any resurgence for the dollar would raise the cost of that borrowing in local currency terms.

Such a move seems more likely when you consider that foreign exchange movements are generally driven by divergent expectations for growth and interest rates. Currencies of countries whose growth forecasts had been upgraded the most this year, such as Mexico and Poland, outperformed over the last quarter, according to J.P. Morgan strategists.

Investor pessimism about the U.S. dollar may have gone too far.

Investor pessimism about the U.S. dollar may have gone too far. Photo: © gary cameron / reuters/Reuters 

The positive vibe around emerging-market currencies should ease as the premise for it weakens. The proportion of developing countries receiving growth upgrades has fallen to just over 40% from 60% in the past month, based on J.P. Morgan’s rolling measure. Asia—a driver of emerging-market growth earlier this year—is losing steam, with industrial production growth dropping to its lowest point in more than a year everywhere except China. Adding to signs of strain, downgrades of emerging-market debt have accelerated.

The U.S. economy isn’t on a tear, but growth elsewhere hasn’t found as firm a footing as investors seem to believe. There is still a 50% chance the Fed will raise rates once more by December, another factor that should be dollar-positive. Jitters are emerging: a stark repricing of currencies last week after central bankers talked about tightening policy led to the largest-ever one-day outflow from the biggest emerging market hard-currency ETF last Thursday, with $343 million being withdrawn, according to J.P. Morgan. That, though, compares with inflows of $14 billion so far this year, meaning there is scope for plenty more outflows.

No matter how fast-footed, investors should remember reversals in sentiment can happen fast.

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