Dollar bulls wait for economy to gain speed

Dollar bulls are feeling the after-effects of a bleak US winter, and as they exit their holdings of the reserve currency, the consequences are registering across global markets.

Doubts over the apparent strength of the US economy have halted a pronounced dollar bull run in recent weeks, as expectations of tighter policy by the Federal Reserve this year have faded.

Now, much turns on whether the US economy has experienced a temporary soft patch, or faces a further run of lacklustre data that leaves the central bank on hold, with the potential for triggering a far larger shakeout across markets, led by the dollar.

Against a basket of its main rivals, the dollar fell to its lowest level since late February on Thursday, illustrating how the faltering economy has left the market in a state of confusion.

There was little to be gleaned from the Federal Reserve statement about the central bank's policy intentions hours after data showed the US economy expanded just 0.2 per cent for the first quarter. The Fed noted that "economic growth slowed during the winter months".

What is plain, says Luke Bartholomew, a fund manager at Aberdeen Asset Management, is that Wednesday's "ugly" economic data, coupled with anaemic inflation, suggest a June interest rate increase is all but off the table.

"[Fed chair Janet] Yellen has made it abundantly clear that rates will only rise when the economy is strong enough to absorb it, and we're probably not there yet," he says.

After heady market chatter in mid-March of parity between the euro and the dollar, the greenback's reversal has come at a vulnerable juncture when many investors were betting on further strength. The worry is that the dollar could fall a lot further as dollar bulls unwind their bets, sparking a further rise in the euro that tightens financial conditions in the eurozone.

"The tide is shifting," says Stephen Jen, head of currency hedge fund SLJ Macro.

That may be welcome respite for those for whom the strong dollar has been especially painful - among them US exporters and non-US corporations holding large dollar-denominated debt, particularly in emerging markets.

But with dollar weakness comes gains for other currencies, particularly the euro - and that is not necessarily to the benefit of eurozone countries and some corporations.

The monetary easing game plan of Mario Draghi, president of the European Central Bank, is for its $60bn-a-month bond-buying programme to stimulate growth, with help from a weaker euro.

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As a result, the German DAX index, dominated by companies whose exports have flourished in a climate of a weakening euro, has been hit hard this week. Asian companies are also under pressure from stumbling US growth, with Tokyo's Nikkei 225 falling 2.7 per cent on Thursday.

Kit Juckes, currency strategist at Societe Generale, says the weaker euro lets European producers compete more for global demand, "but if global demand is just weak, that's not great".

Emerging markets, he also points out, had been dependent on the now slowing Chinese economy for growth.

Whatever the pressure of a strong dollar on emerging market debt holdings, if faced with a choice between a strong US economy and a weak one "a strong US economy trumps everything else", says Mr Juckes.

Mr Jen says a faltering US economy is an issue for Europe and the rest of the world.

"The world is quite dependent on US demand growth," he argues. "What's not going to happen is the US faltering and Europe recovering."

With Europe no longer benefiting as much from currency weakness and lower oil prices, Mr Jen warns: "We are drifting away from the sweet spot Europe was in."

The current loss of upward momentum in the dollar could well turn, and quickly should forthcoming US data hint at a spring rebound and validate the Fed's view that weakness during the first quarter was "transitory".

Some strategists also argue that the Fed could decide to lift interest rates in July, despite the absence of a press conference at that meeting.

Paul Ashworth, of Capital Economics, leans towards a September increase, but points out that Ms Yellen could use her semi-annual congressional testimony in mid-July to signal a move later that month.

According to Brian Jacobsen, chief strategist at Wells Fargo Funds Management, while there is no press conference after the July meeting, "Chair Yellen insists that all meetings are created equal, which means it's still in play".

By then, dollar bull traders like Mr Jen will be hoping for some better clarity on the state of the US economy.

"My own problem is I don't have a narrative," he says. "I don't know why the US economy should slow."

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