Dollar Bulls Have Reason to Smile Whether or Not Rout Deters Fed

  • Biggest gains likely versus emerging markets, Stephen Jen says
  • Analysts see currency climbing versus most peers by year-end

All roads lead to a stronger dollar.

That’s the view of Stephen Jen, co-founder of hedge fund SLJ Macro Partners LLP, who spent 13 years at Morgan Stanley where he helped develop a theory known as the “dollar smile.” He’s predicting gains versus emerging-market currencies in particular, whether or not the Federal Reserve succeeds in raising interest rates without sparking market turbulence.

“What we have now is a very strange situation where the U.S. economy continues to grow but there’s elevated risk of a financial selloff, and it’s actually the most positive environment for the dollar,” London-based Jen said by phone Sept. 9. “The dollar should be supported in multiple scenarios.”

Investors who bought the currency to speculate that the Fed would tighten monetary policy are seeing gains even as markets push back bets on when the central bank will raise interest rates. The greenback has surged against the currencies of commodity producers and developing nations since an Aug. 11 devaluation of China’s yuan that fueled concern growth in the world’s second-largest economy was slowing and sparked a global rout in shares.

Analysts predict the dollar will appreciate against more than half of its 16 most-traded peers by year-end.

Meanwhile, hedge funds are piling into bets the greenback will gain against emerging-market currencies, said Sam Diedrich, a director at Pacific Alternative Asset Management Co., which oversees about $9.5 billion in hedge-fund investments.

“Long-term structural bullish dollar positions are still out there,” he said. “There are a lot of reasons to think that U.S. dollar strength will continue for quite some time, particularly against emerging markets.”

Jen’s analysis resembles his “dollar smile" theory, which is based on a chart that predicts gains for the world’s most-traded currency when the U.S. economy is growing strongly or in a deep slump.

While the U.S. currency weakened in 2004 when the Fed started its last cycle of rate increases, it climbed 8.7 percent against major peers the following year as the central bank boosted its benchmark by 2 percentage points. The currency again surged in 2008, with the Bloomberg Dollar Spot Index gaining 8.9 percent, as the global financial crisis drove demand for haven assets. The index is up 7.1 percent this year.

The lowest jobless rate in seven years hasn’t cemented a September move by the Fed as sentiment also finds itself driven by equity- and currency-market turmoil. New York Fed President William Dudley said on Aug. 26 recent volatility had made a September liftoff “less compelling.” 

The probability of a 25 basis-point increase at the Fed’s Sept. 16-17 meeting dropped to 28 percent on Thursday, from 54 percent a month earlier.

Capital Outflow

“The market will only delay a Fed-hike expectation rather than take it off the table,” said Mitul Kotecha, head of Asia-Pacific currency strategy at Barclays Plc in Singapore. “We don’t see much respite for Asian currencies, not only are there pressures from China but at the same time there’s continued outflow of capital and slowing economic growth.”

The exchange rates of nations outside Asia including Brazil, Turkey and South Africa will also come under pressure as will the euro, Kotecha said.

A gauge tracking 20 developing-nation currencies has fallen 4.5 percent versus the dollar since Aug. 10, led by a 12 percent drop in Brazil’s real and a 8.7 percent decline in the Malaysian ringgit. An index tracking the currencies of 10 commodity producers including Australia, Russia, Brazil and New Zealand has fallen 5 percent.

Waning speculation that the Fed will raise interest rates opens up the possibility of a stronger dollar if an increase in the benchmark does materialize, said Ray Attrill, co-head of currency strategy at National Australia Bank Ltd. in Sydney.

“You get support from higher interest rates than are being discounted, and you get support because equities sell off, and you maybe do get a little bit of the dollar smile at the same time,” he said.

(For a Currencies column daily alert: SALT FXCOL.)

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