Signs of stronger U.S.
economic growth and inflation are becoming a central focus of financial
markets, helping lift the dollar to its highest level since January. Yields on
the U.S. 10-year Treasury note last week crossed over 3% for the first time
since 2014, evidence that part of the economy is returning to more normal
conditions after a long stretch when bonds yields had hovered near historic
lows.
The U.S. economy grew at
2.3% in the first quarter, according to government data released on Friday,
expanding faster than the 1.8% analysts were expecting. A rise in the
employment-cost index also signaled rising wages, analysts said. If Friday’s
closely watched jobs report shows wage growth approaching 3%, as it did in
January, that could provide more support that inflation may be beginning to
stir.
Economists, meanwhile, are
turning more skeptical that Europe can keep growing at last year’s pace. Recent
data like German manufacturing and weaker Eurozone inflation have signaled a
slowdown. U.K. growth also eased in the first quarter, while recent Japanese
economic data has been mixed.
“Many people were bearish
the dollar because they thought the rest of the world was doing quite well,”
said David Woo, head of global rates and currencies at Bank of America Merrill
Lynch. “It’s very clear that this theory has been severely challenged.”
The bank recently urged
investors to bet the euro will decline to $1.15 in coming months, from around
$1.21 Friday.
In Friday’s trading, the Dow
Jones Industrial Average was flat, and stocks were slightly down for the week
following one of the busiest periods of the first-quarter corporate earnings
season. Investors will be watching next week for earnings from blue chips
like Apple Inc. andMcDonald’s Corp.
When the dollar was
weakening, analysts were puzzled why the interest rate differential between
Treasurys and foreign bonds didn’t support a stronger U.S. currency. But now
that dynamic may be playing out. The gap between U.S. 10-year Treasury yields
and those on German bunds is at its widest since 1989, according to DWS.
With investors increasingly
believing the Federal Reserve may raise interest rates four times this year,
that spread could continue widening and offer additional dollar support.
The WSJ Dollar Index rose
1.1% last week, its best weekly-performance since 2016, and the dollar ranks as
one of the currency market’s top performers in April. Last year, the dollar
fell 7.5% as investors came to believe that growth would accelerate faster
abroad as the U.S. economy reaches the end of its cycle.
Dollar bulls have another
reason for hope. The futures market is still highly skewed against the U.S.
currency, with the largest bearish dollar position since 2011 earlier this
month, according to data from the CFTC. Further dollar gains could force some
of those investors to cover their bets and buy back the dollar, pushing it
higher, analysts said.
Rising yields are making it
expensive to remain short the dollar, as investors have to borrow in the U.S.
currency to bet against it, said Ugo Lancioni, head of global currency at
Neuberger Berman.
A rising dollar has broad
implications for markets and the economy. While it can attract more foreign
capital to U.S. bond markets, it can bruise the earnings of U.S. multinationals
by making their products less competitive abroad. Around 60% of companies
reporting first quarter results said that dollar weakness had helped boost
their earnings, according to FactSet data gathered in mid-April.
Facebook said last week that “foreign
exchange tailwinds” contributed $536 million to its first quarter revenue,
while pharmaceutical company Bristol-Myers
Squibb also indicated favorable foreign exchange dynamics provided a 4
percentage point boost to revenue.
Some investors believe the
dollar rebound could prove temporary. For one, the U.S. economy is later in the
economic cycle and the European Central Bank has barely begun tightening its
monetary policy. Analysts expect the ECB to make a decision in June or July to
phase out the bond-buying program by December—four years after the Federal Reserve
halted its own quantitative-easing program.
Moreover, many analysts also
believe the dollar’s bullish and bearish cycles tend to last between five and
seven years, on average. That would mean the U.S. currency is in the early
stages of an extended period of decline, after a bull market that began in 2011
and peaked in early 2017.
But a temporary dollar rally
can last months, even in the midst of a bear market period. That is what
happened during a seven-year dollar slump during the previous decade: in 2005,
the dollar rose 13% over 11 months, before returning to a downward trend the
following year.
Some think growth momentum
will likely shift back to Europe in the coming months, spurring the ECB and
other central banks to continue normalizing monetary policy.
The dollar’s move “is a bear
market rally,” said Jason Draho, head of tactical asset allocation Americas at
UBS Wealth Management.