31 Jul 2017

  • The once invincible US Dollar is starting to look fragile
  • Inflation to be the dominant driver in the third quarter
  • It might not be over for the Greenback just yet

In the tenth installment in the X-Men film series, an aged Wolverine, Logan, undertakes a final adventure in a dystopian future. His healing factor has faltered and, as a result, his body has aged and can no longer heal at the same rate as before. Similarly, the once invincible U.S. Dollar is starting to look fragile.

After rallying 30% between mid-July 2014 and December 2016, the US Dollar retraced a third of its appreciation this year and it is the weakest currency in G10 year-to-date. Is this trend going to continue into the end of the year? It is pretty clear that foreign central banks have moved away from specifically targeting currency weakness and are more open to allowing their currency to appreciate. Devaluing the currency doesn’t work when everyone is doing it. Even the Swiss National Bank (SNB) was forced to accept a stronger Swiss franc and abandon the floor of 1.20 against the euro. This change from explicitly keeping their currencies weak to allowing some appreciation is significant as competitive currency devaluation was the main driver for the first leg in the US dollar rally.

The table may have turned now, with foreign central banks sounding more hawkish while the Federal Reserve had to acknowledge lower than expected inflation in the US. However, simply extrapolating the currency moves year-to-date and looking for further US dollar weakness might be too dangerous. An aged Logan managed a strong comeback at the end of the movie. We would be surprised if the same happens in the foreign exchange market. Some higher than expected inflation numbers in the US might easily trigger a strong comeback for the Greenback. Inflation will remain the most dominant driver in the foreign exchange markets in the coming months. The US dollar is already overvalued and one of the key reasons for its rally is no longer valid as foreign central banks are open to allow their currencies to appreciate. However, higher interests rates in the US will continue to support the US dollar until foreign central banks start normalizing more aggressively.

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