The U.S. dollar is likely to depreciate over time in 2019, despite its near-term strength backed by the favorable U.S. interest rates and market volatility, UBS predicted in its Year Ahead 2019 report.
The forecast report released on Wednesday, rolled out by the Chief Investment Office of UBS Global Wealth Management (GWM), noted that the dollar has remained overvalued thanks to "marked positive short-term interest rate differentials" compared with other countries, as the U.S. Federal Reserve has continued its rate hikes.
However, the report pointed out that the currency's advantage would possibly be pared next year, because the dollar will bear downside pressure both domestically and geopolitically.
FED'S FUTURE MOVES TO WEIGH ON DOLLAR
The Fed is expected to approach the end of its rate-hiking cycle in 2019, and the U.S. fiscal and current account deficits will set the dollar on a downward track, said the Swiss multinational investment bank and financial services company.
The Fed last week built up the possibility of interest rate hikes in December for the fourth time this year, saying it was "likely to be warranted fairly soon," according to the minutes of the Nov. 7-8 session of the Federal Open Market Committee, which sets interest rates.
However, the Fed stressed that it would consider changing the term "further gradual increases" for the federal funds rate in its future statements, spurring concerns over how long the central bank's roughly quarterly hikes will continue in 2019.
Geopolitically, although the lingering uncertainty over U.S.-China trade tension has propped up the dollar's demand as a safe-haven currency, Europe and Japan are carrying out policy normalization, which UBS believed would put a damper on the greenback's comparative edge.
Mark Haefele, chief investment officer of UBS GWM, said other currencies were undervalued, as the demand for the dollar as a safe-haven currency increased due to persistent market volatility. However, potential changes in U.S. interest rates will weigh down the greenback in the year ahead.
"I think what we say is that over the short term, the (U.S.-China) trade tension could increase the dollar's strength a bit from here. But a lot of interest rates differentials, the higher yields (of short-dated Treasury bonds) in the United States, are priced in now. So over time we will expect the overvalued dollar to fall," Haefele explained.
The U.S. dollar extended losses in late trading on Tuesday, as an inverted yield curve of U.S. Treasury bonds sparked concerns about a slowdown in U.S. economic growth.
Two-year bond and three-year bond yields surpassed the five-year yield for a second day on Tuesday, creating an inversion of the yield curve, which is normally viewed as a precursor of an economic downturn.
Adding to the adverse impact, UBS also saw "limited further upside" of 10-year U.S. Treasury bond yield in the future.
Haefele said that the U.S. central bank's quantitative easing would also worsen the curve by shrinking the yields of the longer-dated U.S. government bonds.
"The inversion is not such a great predictor of a recession in general as there can be many months of stock out performance before that recession happens. Second, in this cycle, the central bank's quantitative easing suppresses the longer-dated part of the yield curve maybe 100 basis points ... So that flattens the curve," he elaborated.
"You can't just look at these yield curve and compare it to the past, because the central bank has reacted so differently. This forced flattening can persist as long as there is no inflation pickup," he added.
POLICY NORMALIZATION ELSEWHERE AROUND WORLD
Looking ahead, the dollar's strength will wane and depreciate against other major currencies in the world. There will appear wide interest rate differential between the greenback and such other currencies as the euro, the Swiss franc and the Japanese yen, as the central banks of the above nations begin to normalize their monetary policies, according to the report.
"The European Central Bank (ECB) will only be starting to normalize interest rates, which will cause the differentials to shrink and the dollar's advantage to recede," USB stated in the report.
Europe has also sought to promote wider global use of its currency. The European Commission published on Wednesday proposals to improve the euro's role in international payments and as a reserve currency, especially in financial and commodity markets, as the U.S. withdrawal from Iran's nuclear deal had forced many European companies to halt business with Iran.
Similarly, the Swiss National Bank, UBS noted, will also raise its target rate after a first rate hike by the ECB in 2019 amid global uncertainty, which will raise the Swiss franc against the dollar.
Elsewhere in Asia, since Japanese prime minister has depreciated the Japanese yen (JPY) to shore up the country's economy, the currency is currently undervalued.
The Bank of Japan (BOJ) has been considering pulling back its monetary stimulus as inflation is getting back to normal. Under such a status quo, the Swiss financial institution believed the JPY "could start to strengthen again."
Another boost to the JPY is the projected rising of Japanese 10-year government bond yields in 2019, "as the BOJ starts to slowly normalize its monetary policy," according to the report.
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