Are foreign-exchange (forex) traders the most far-sighted players in the capital market? Can the almost $5 trillion traded in and out of the dollar on a daily basis be wrong?
Just two months after Donald Trump's election the greenback began to weaken – ending a rally since mid-2011. Did the forex market immediately anticipate that Trump's unorthodox political style would harm the global currency? Did the forex market fear – from the outset – economic overheating, a ballooning twin deficit, the termination of international trade agreements, harsh treatment of allies, friendship with foes, and the loss of the dollar's appeal as the dominant settlement and reserve currency?
This, of course, is just one way of looking at the decline in the dollar since Trump became U.S. President. We could easily find a fistful of other reasons, compelling causalities and impressive correlations to explain the dollar weakness that began at the beginning of 2017. When it comes to foreign exchange, it's not difficult – after the fact – to dip into the large pool of short, medium, or long-term factors in order to justify past currency moves. You can take your pick for the most recent dollar push from 1.25 to 1.15 against the euro. Renewed long-term Eurozone concerns prompted by Italy; medium-term, recently accelerating U.S. growth and European slowdown; short-term, investor positioning and positive signals from technical analysis?
The reality is that you seldom get far in the forex market by relying on only one explanatory model. Currencies are impacted by a host of factors whose impact waxes and wanes over time. The challenge for us as forex strategists is to assess which will become the key driver for a currency, and when. It is possible to recognize long-term developments early on but still be on the wrong side of the market for long periods. For that reason we work with models based essentially on three pillars: macroeconomic fundamentals; sentiment and positioning; and market technicals.
This is not a rigid, purely quantitative model but a dynamic framework that we regularly synchronize with our qualitative assessment. Our Chief Currency Strategist, Stefanie Holtze-Jen, sums up her work in this way: "The end game in currency trading is to have a good feeling for the interplay of the various drivers, especially when long-term factors come to the fore again and dominate short-term factors. Alongside the fundamental macroeconomic developments, we always keep an eye on investor positions and also the signals provided by the charts."
While from a strategic standpoint we had been expecting a stronger dollar for some time, in tactical terms it was only in mid-April that we implemented the position in many of our portfolios. At that point it appeared to us that the positioning of speculative futures traders was euro-euphoric to the point of being extreme, and at the same time EUR/USD had broken out of a multi-week sideways channel, which provided us with an important technical signal.
Thanks to an impressive rally, the dollar subsequently hit our target of 1.15 sooner than we had anticipated. At our quarterly strategy conference we then reviewed our tactical and strategic dollar outlook once again and concluded that in the short term extreme market positions have been unwound and the exchange-rate chart is not providing any clear signals. At the same time, we see some structural factors that could be a drag on the dollar in the long term and the euro in the medium term. Overall, we believe these various forces are currently balanced, with the result that we expect EUR/USD to trade sideways over the next twelve months.
As with every currency call, this is based on the current situation and our latest macroeconomic forecasts. It is, however, highly probable that by mid-2019 there will have been enough new surprise events to give us reason to call for a clear directional move in this currency pair.
Stefan Kreuzkamp - CIO - DWS