Some investors are interpreting recent dollar stability as a sign its bout of weakness is nearing an end. We think those expecting a reversal are in for a disappointment.

James Barrineau

After a rapid fall, the dollar has retraced some ground. Some are suggesting this means the dollar's fall is over. We believe more caution is advisable.

The US twin deficit deterioration remains very firmly in place and central banks are similarly inclined to let loose monetary policy continue in an uneven recovery. Therefore, fundamental drivers for a meaningful reversal seem scant.

We would view a "taper" move by the Federal Reserve (Fed) as a significant cause to re-think. But while there has been some discussion of this, we believe it is very premature, and unlikely to drive markets for most of this year at least.

We have to go back to 2002 for the last sustained dollar bear market. In that period, the first move down before a correction was just over 13% in seven months, as the chart below shows. The recent drop has been almost identical, over only a slightly longer period.

Current positioning surveys suggest the short dollar trade is likely over-extended, so a retracement should not be mistaken for a fundamental shift. In 2002 that retracement was about 4%; today it has been around 2% to date.

Our second chart shows the deterioration in the US trade balance - a level last reached around the dollar lows of the mid-2000s. With the level of fiscal deterioration set to accelerate as well, ingredients that are very similar to the previous multi-year period are well intact. The combination of these fundamental factors and similar price moves suggests any re-tracement is more likely to be short-lived than any indication that the dollar weakness has run its course.

Recent Fed-speak has sparked a notion that the Fed might taper its balance sheet growth while keeping rates at zero. Given the 2013 experience of a rise in the dollar, such a move would cause a re-think. However given continued weakness in employment and a sluggish rollout of vaccines we are likely months away from contemplating such a change.