Here Is Why The Dollar Rally Is Far From Over - Goldman Sachs

The house view at Goldman had traditionally been that the Dollar is a weak currency. That changed in April 2014, when we became Dollar bulls, estimating that the coming monetary policy normalization in the US could drive the Dollar around 15 percent stronger.

In the event, the Dollar rose 20 percent in the second half of 2014, with much of that move reflecting Euro and Yen weakness as the ECB and BoJ pursued aggressive monetary easing. However, in the FOMC meeting exactly a year ago, the Fed shifted dovish, we think in part because EUR/$ had gone from 1.14 to 1.05 in the previous three weeks, and the Dollar – on a trade-weighted basis versus the G10 – has been in a range ever since. In fact, with markets debating if central banks are “out of bullets,” the Dollar has fallen recently and there is growing concern that the Dollar strengthening cycle may be over.

We revisit the analysis we did in April 2014. Back then, our main point was that a normalization of policy, i.e., a higher Fed funds target, would necessarily imply a stronger Dollar. Given that policy normalization has barely begun – we are 25 bps into it – we believe that the analysis still stands and that the Dollar rally is far from over.

Much as in April 2014, we can estimate the potential for Dollar upside if the 2-year rate differential moves in line with our forecasts for G10 policy rates. As Exhibit 2 shows, this implies that the 2-year differential could be between 120 bps and 150 bps higher than its current level, depending on whether we use the spot or 2-year forward differential. This translates into potential Dollar upside of between 10 percent and 15 percent, i.e., similar to the kind of estimates we had almost two years ago.

It might seem puzzling that the potential for Dollar strength is largely unchanged, even though the Dollar has obviously appreciated a lot. Intuitively, this is because monetary policy normalization has really only begun, in addition to rates markets taking a very dovish view relative to our expectations for Fed tightening. Implicitly, our estimates for Dollar strength are largely a reflection of the divergence between our Fed call and what markets are pricing. And there is admittedly a genuine tension there. On the one hand, some Fed speakers have recently flagged the importance of financial conditions in their decision making process. On the other hand, labor market slack is steadily diminishing and core PCE is rising towards two percent.

Today’s FOMC will be an important marker in resolving this tension. Ultimately, we believe that the Dollar rally is far from over.

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