BNY Mellon: USD Falls out of Favor

November 2, 2018

Simon Derrick, Chief Currency Strategist, BNY Mellon

The positive performance of a good number of Asian equity markets on the first day of the new month (only the KOSPI & TOPIX stood out as having had an uninspiring day) further encourages the view that the worst of the October volatility is likely over.

The question now is how that plays out from an FX perspective.

While the initial reaction to the tentative turn around in sentiment at the start of this week was for the USD to strengthen across the board thanks to the recovery in US yields, it’s noticeable that this pattern has changed since the middle of the week.

Both the JPY and USD are now out of favor while a wide range of currencies that had come under pressure in recent weeks (from the AUD to the ZAR) have seen very healthy recoveries.

Perhaps the most telling moves, however, have come in oil-related currencies. Oil prices have come under renewed pressure in the latter part of this week thanks to several reports of rising supply.

A Reuters survey indicated that OPEC production is now at its highest levels since 2016, while US Energy Information Administration data show US crude output at record highs in August.

These losses continued a trend that emerged at the start of October. Unsurprisingly both the CAD and NOK had tracked most of this move lower over the past month.

It was therefore very interesting to see the NOK and CAD making health gains yesterday morning against the USD, despite the new lows seen in the oil markets. This potentially says a great deal about the pace at which the USD is falling out of favor right now.

This comes at a time when the similarities with the last two great USD rallies (1980-1985 and 1995-2002) remain noticeable.

These include the broad length of time each of these trends persisted, as well as that both were driven by a relative tightening of monetary conditions that proved mild enough to support bull markets in stocks through much of their lives.

The end of the USD rallies in 1985 and 2002 also carried some distinct similarities, with both being characterized by declining realized volatility and a notable narrowing in the gap between the Fed Funds Rate and headline inflation.

It’s therefore worth putting the current numbers for the USD in context.

Firstly, even after three years of rate hikes the gap between headline inflation and the Fed Funds Rate has only just got back to flat, which is where it stood when the policy tightening started.

In contrast, at the turning point of the USD rally in 2002, the Funds Rate still stood 60 bps above headline inflation, while in 1985 it stood over 470 bps higher.

Meanwhile, 21-day realized volatility stands at roughly the same levels it did just ahead of the previous turning points.