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Problems in Italy, monetary policy divergences and the October correction have all helped to boost the dollar in recent months. These issues now seem to have been fully factored in by investors who may well start to reduce their exposure.

Jean-François Gillardin, Head of Discretionary Portfolio Management, discusses the issue in an article in the Luxemburger Wort on 30 November 2018.

Problems in Italy, monetary policy divergences and the October correction have all helped to boost the dollar recently. These issues now seem to have been fully factored in by investors who may well start to reduce their exposure.

In finance, as everywhere else, opinions can change rapidly. In the early months of the year, investors deserted the dollar in droves and preferred European and emerging market equities to US equities. Barely a year later and the situation is completely different. The dollar has appreciated by around 5% against the euro and US equities have withstood the recent bouts of market turbulence better than their European and emerging market counterparts.

However, the main long-term arguments in favour of the dollar depreciating continue to be relevant. Key among them are the worsening public finance deficit following Donald Trump’s tax reform, the US current account deficit compared to the eurozone’s surplus and, to a lesser extent, lack of confidence and lack of visibility in the US President’s policy.

Political risk had been heavily underestimated in the eurozone and returned with a vengeance in May following the Italian elections. And that is exactly when the dollar started to rally against the euro. The formation of an anti-system government prompted fears of Italian fiscal slippage and drove up Italian bond yields. As the peripheral countries are more indebted now than they were in 2011, some investors even envisaged a return of the sovereign debt crisis.

The resilience of US growth has also forced investors to revise their anticipations for monetary tightening in the United States. In January, four interest rate hikes were expected between then and December 2019. In addition to the three rises that have already taken place this year, the Fed’s monetary policy committee is likely to raise interest rates three more times – including one at its December meeting – over the next 12 months.

Italian government squeezed between the EU and its electorate

In contrast, we have seen the opposite scenario in the eurozone. At the beginning of January, the market expected the ECB to start its monetary tightening cycle in June 2019, followed by a second interest rate rise in December. Now, there are no plans to raise interest rates in this time-frame. Expectations that interest rates would be increased twice more in the US coupled with the decision not to raise interest rates in the eurozone helped to widen the US/German bond yield gap and, at the same time, contributed to the dollar’s appreciation.

The significant market corrections in October and subsequent return of risk aversion benefited the dollar, which is still the ultimate safe-haven currency. Uncertainty over the future course of the trade war between China and the United States also helped to boost the dollar.

For the dollar to continue to appreciate against the euro, we would need to see further deterioration in relations between Italy and the eurozone. However, the latest news seems to be going in the opposite direction, with the economy minister saying that the government is planning to cut the budget deficit slightly. It remains to be seen whether this announcement is just intended to instil some calm on Italian bond yields or if it really marks the start of a more constructive dialogue between the different parties. However, at this stage, we cannot rule out the current government suddenly coming back with proposals designed to satisfy its voters.

On the monetary policy front, the scenario for the euro could be more favourable. Given the current slowdown, although it is difficult to imagine a more-aggressive-than-anticipated cycle of interest rate hikes in the eurozone, the idea that Fed members might gradually soften their line is a possibility as the global slowdown could force them to halt the monetary tightening cycle sooner than the market expects.

The euro/dollar exchange rate has mainly fluctuated on the back of three issues – Italy, monetary policy and risk aversion – which now seem to have been fully factored in by the markets. While, in the short term, we cannot rule out further appreciation, the long-term indicators point to the dollar’s depreciation. On this basis, it could be the time to take profits on the currency.

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