Last week, the European Central Bank (ECB) and the Bank of Japan (BoJ) maintained their accommodative monetary policies, which were in line with market expectations. Both policy-making bodies referenced the fragility of recent economic upticks and the persistent inflation downticks in their regions. Yet, in the face of easy policy, the euro hit 30-month highs versus the U.S. dollar (now up 10.8% versus the dollar year-to-date). Also strong, the Japanese yen is now up 5.2% this year versus the dollar (trade weighted).

We have to ask, "Are the EU and Japanese economies really doing so much better than the U.S. that their respective currencies should demonstrate those levels of relative strength?" In other words, why are investors buying the euro and yen, while ostensibly selling the dollar?

We'd note that OECD GDP growth projections for the euro area are 1.8% for 2017 and 2018. For Japan, 1.4% and 1.0%. For the U.S., 2.1% and 2.4%. So the answer is that U.S. economic growth expectations are a little better. Recent housing and leading economic index readings have also been on the stronger side. (As an aside, it may surprise you that the euro area unemployment rate is still an elevated 9.3%, with Spain's unemployment rate at 19.75%, higher than Iran's 12.5%.) We'd note that export growth for the euro area and Japan is stronger than for the U.S., but that may change if the euro and yen continue to appreciate versus the dollar.

Have interest rate differentials shifted so that bonds are more attractive in the EU and Japan than the U.S. (causing the carry trade to reverse as investors sell dollars to buy euros and yen)?

Germany's 10-year yield is 0.506% and Japan's 10-year yield is 0.071% versus the U.S. 10-year Treasury yield of 2.233%. In fact, the spread between the U.S. and Germany's 10-year yields has widened from -157.1 bps to ‑172.7 bps over the past year, while the U.S.-Japanese spread has widened from -179.5 to -216.2 bps. Both spreads suggest it is even more advantageous for international investors to seek U.S. yields. So the answer is no.

Could it be the self-reinforcing notion of momentum, whereby carry trade investors are winning on the yield spread but giving it back as the dollar declines? Partly. But at least a portion of the trades is hedged. So while carry trades are definitely being unwound as the dollar declines, it probably isn't the main driver.

Could it be as simple as investment money flows? Again, partly. According to ICI, year-to-date through 7/12/2017, mutual fund investors have sold a net $6.5 billion in Domestic Mutual Funds, while purchasing $134.1 billion of World mutual funds. These amounts aren't much in the face of multitrillion-dollar currency markets but can reflect sentiment trends.

Maybe inflation differentials and expectations for each region are causing the currency movement? Not if you ask the respective central bank authorities. All have made clear that inflation targets have not been met, and aren't likely to be met in the foreseeable future. Eurozone CPI was 1.3% y/y and is in a downtrend after peaking this year, U.S. headline CPI for June was 1.6% y/y and Japan's latest inflation measure shows a 0.40% y/y rate.

While all of the aforementioned issues play their part, it is more likely investor perception of relative central bank policy that is causing the trends as the multitude of channels making bets on currency trends take their cues from the higher powers (central banks).

Our view is that while the Fed was the first central bank to begin the process of normalizing monetary policy in December 2015 (the BoE also attempted normalization as recently as 2015, but relented), recent signs of economic weakness are testing their resolve. The dollar peaked at the beginning of the year and has since retreated, nearing its April 2016 lows as the Fed oscillates between the trajectories of the Fed rate hike path and reducing the size of their balance sheet.

At this point, the dollar is still overvalued on a Purchasing Power Parity basis versus most of its major trading partners, but the level of overvaluation is declining.

Furthermore, short-, intermediate- and long-term quantitative U.S. dollar models remain on sell signals. Since 1979, when all three models have been on sell signals, the U.S. dollar index has declined a -7.9% annualized rate. The historical rate of return becomes positive when two of the models turn positive (see table below).

U.S. Dollar Index versus NDR Timing Models

Bottom Line: The dollar's direction is likely to influence our levels of international exposure (hedged and unhedged), small cap versus large cap exposure, as well as our sector allocations. At this point, we aren't ready to make a shift in our portfolios in anticipation of a stronger dollar, but we are watching closely for the opportunity.

Have a wonderful week,
Donald L. Hagan, CFA

— Written 7-23-2017

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