The Dollar's Resilience and Overvaluation Against G10 Currencies Amidst Quiet Markets

FX Daily: Economic resilience keeps dollar ‘expensive’

Our short-term fair value model indicates the dollar is overvalued against all G10 currencies, but recent price action suggests it will take some poor US activity data to prompt a USD correction. That may not happen this week, as developed market calendars are quite dry. Elsewhere, the Reserve Bank of Australia paused, but the AUD demise looks overdone.

 

USD: Comfortably overvalued

With US trading halted yesterday for the Labour Day holiday, global FX markets started the week on a very quiet tone after Friday’s big swings. In short periods like this one where attention temporarily shifts away from the US, developments in China emerge as the main driver for global sentiment. Yesterday, hopes of fiscal stimulus triggered a rebound in Chinese property stocks, but a below-consensus read in the Caixin Services PMI overnight generated fresh pressure on Asian equities.

While the equity compartment appears to respond more symmetrically to good and bad news coming from China, the currency market remains more responsive to negative developments, as the ongoing period of dollar strength contributes to limit gains for most Asian EMFX. More specifically, the renminbi still faces pressure from easing monetary policy in China, to which the People's Bank of China (PBoC) has recently paired a cut to the FX reserve ratio requirement to try and insulate the currency-depreciation effects. This morning, we are seeing USD/CNY trading higher after the poor PMIs and re-testing the 7.30 area, which has been the line in the sand for the PBoC.

On the US front, we discussed in yesterday’s FX Daily how this week’s data calendar looked unlikely to radically alter the narrative of US economic resilience, which has been the foundation of recent dollar strength. Today’s calendar is quite light, only including July’s factory orders.

From a technical point of view, we must note that the dollar’s outperformance in August was not entirely justified by market drivers (i.e. relative rates, equity, and commodity dynamics). Our short-term fair value model shows some dollar short-term overvaluation against all G10 currencies, ranging from quite moderate for GBP (less than 1%) to quite stretched for Scandies (above 3%). Still, one characteristic of the recent dollar price action is that it has taken poor US data to initiate any substantial correction, and we suspect a deterioration in the economic outlook remains the only real path for the mis-valuation gap to be closed. What this gap is telling us now is that the dollar correction, once the US data turn, can be quite rapid and substantial.  

 Francesco Pesole