With the Fed nudging investors in recent weeks to expect the first rate rise in December, the strong jobs report on Friday now has everyone convinced that a December hike is inevitable. In our opinion, the best way to position for Fed rate hikes is to be long the US Dollar. Initially, we think the US Dollar will be strong across the board. Moving in to 2016, we think the Dollar will be strongest against selected Emerging Market currencies.
Two weeks ago post the ECB meeting, we said that we felt that the Euro/US Dollar exchange rate had entered a new bearish phase. Having closed that week around 1.10 we said that we felt the 1.05 area would be tested and ultimately we would see a move to parity. With the Euro now just above 1.07 our forecast appears to be on track.
It’s not that hard to be bearish of Euros at the moment, with Mario Draghi hell bent on weakening his currency. That said, one of the main drivers of the recent weakness against the US Dollar is the widening rates differential in favour of the US. In the chart below, we show how the Euro/Dollar FX rate has been tracking interest rate differentials as measured by the difference between the respective 5 year Government bonds. To be clear, the red line depicting the rate differentials is inverted and illustrating that 5 year US Treasuries yield about 1.7% more than German 5 year bonds.
As well as being bullish the US Dollar against some of the major currencies such as the Euro, our preferred structural bullish Dollar trade is against selected Emerging Market currencies. We have laid out the bearish EM scenario quite a few times in the last year or so, and a strong US Dollar on the back of Fed rate rises will potentially just make matters worse. Commodity sensitive currencies continue to struggle with most commodity prices remaining depressed and supply still expected to exceed demand for some time to come. However, many commodity sensitive currencies have already depreciated markedly in the last two years. Our focus remains on mercantile Asian currencies which we believe are likely to weaken their currencies especially if the Euro and Yen continue to depreciate on the back of ultra easy monetary policies.
The chart below shows selected EM currencies (and Japan) against the US Dollar over the last 5 years. It is clear that North Asian mercantile currencies have held up incredibly well compared to other EM especially those exposed to commodities. With Japan having depreciated significantly over the period, mercantile Asia is struggling to compete and in a world where currencies have become an active tool for policymakers, we believe that Asian currencies will be managed lower over the next 12 months.
Quickly looking elsewhere. In the current environment of policy divergence between US and Europe, and a strong Dollar, we expect European equities to outperform the US. We would also expect continued underperformance of EM equities.
In fixed income, markets are pricing in a series of rate rises in the US over the next couple of years. We still believe that the Fed will only be able to raise rates a couple of times in this cycle. If we are correct in this, then the longer end of the interest rate curve (the Dec ’17 to Dec ’18 EuroDollar contracts) is beginning to offer some value. As for US Bonds, they have suffered another tough week, and may continue to trade poorly as investors position for the start of a rate rising cycle and reserve managers remain forced sellers. However, relative to core European Government bonds, a pick-up of 1.7% in the 5 year and 1.6% in the 10 year actually looks quite attractive to us.
We will cover equity and bond markets in more detail next week, however we think the potential in these markets is more nuanced than a simple bullish or bearish forecast for the next few months. Relative value trades appear to have better risk reward potential with European equities preferred to EM and US and US bonds preferred to German bonds. The message in currencies is simpler. We expect the Dollar to remain strong against most currencies with EM being the weakest over the next few quarters.