Investors are positively inclined towards the dollar. A net 58% of global fund managers believe that the US currency is undervalued, the second highest reading in more than 10 years, according to Merrill Lynch. US futures market investors, excluding “commercials”, are moderately long the dollar against other developed market currencies, based on the weekly commitment of traders report*.

Dollar bulls expect the currency to be boosted by a continued rise in US / foreign interest rate differentials as the US economy grows strongly over the remainder of 2014. Monetary trends support optimism about US economic prospects: six-month real narrow money expansion rose to a 17-month high in May and is stronger than in most other developed economies.

The bullish argument, however, ignores recent deterioration in the capital account of the balance of payments. The current account deficit has been stable but the balance of direct and portfolio investment flows has moved from a significant surplus in 2012 to a small deficit in the latest 12 months – see chart. The “basic balance”** deficit, therefore, has risen to its highest since 2009.

The capital account has been weakened by a rise in portfolio investment outflows, partly reflecting the ebbing of the Eurozone crisis and optimism about “Abenomics” in Japan. Higher US portfolio investment overseas could be sustained as the global economy improves. The direct investment deficit, meanwhile, could widen as US corporations step up foreign take-over activity, partly for tax reasons.

A basic balance deficit requires an offsetting surplus on the short-term capital account. US economic strength and a rise in US / foreign interest rate differentials may attract a larger inflow of short-term capital but there is no guarantee that this will be sufficient to outweigh the wider basic balance deficit, resulting in upward pressure on the dollar. Bulls may continue to be disappointed.

*The net long position against six other developed market currencies was equivalent to 15% of open interest as of last Tuesday.
**Basic balance = current account plus long-term capital flows (conventionally defined as direct / portfolio flows).