* Dollar hits highest since May 2017
* Economic sentiment swings further in U.S. favour
* Repo flare-up adds to demand for dollars
By Saikat Chatterjee and Tommy Wilkes
LONDON, Oct 1 (Reuters) - The dollar surged to a 29-month
high against a basket of rival currencies on Tuesday, while
pummelling the euro to its weakest since May 2017.
While the U.S. currency has been in favour for several years
thanks to its relatively high interest rate and a strong
economy, the ongoing trade war with China and a scramble for
funding in U.S. money markets has added fuel to the fire.
The list of reasons for the dollar's strength won't make for
easy reading for U.S. President Donald Trump, who has frequently
accused other countries of manipulating their currencies and
called for a weaker dollar.
Below are a series of charts explaining just why the U.S.
currency .DXY EUR=EBS is so strong.
HOW WELL IS THE DOLLAR DOING?
The dollar's outperformance is particularly broad, with an
index compiled by Commerzbank showing that measured against a
swathe of rival currencies it has risen more than 3.5% since
July 1.
The euro has not declined as much, given it has held up well
against a weakening yuan - China is one of the euro zone's
biggest trading partners - but the sheer size of the dollar's
rally has left the single currency down 0.5% over a similar
period.
The dollar has gained almost regardless of what has happened
with U.S.-China trade negotiations, which have emerged as a
principal determinant of market sentiment under Trump.
When talks with Beijing have broken down, investors have
piled into the dollar looking for a safe haven thanks to its
deep liquid markets.
Yet when a truce in the trade war has seemed within reach,
traders have also bought the greenback, anticipating an economic
boost from any trade deal.
SENTIMENTS DIVERGE
The relative outperformance of the U.S. economy has been a
significant driver for dollar strength in the last two years,
but it is signs of a deepening downturn in the euro zone that
have played a major role recently.
According to Citigroup, the gap between the euro zone and
the United States on an economic surprise index has risen
sharply. Europe is now underperforming by a bigger margin than
at any time since late 2017.
That corresponds with a move lower in the euro from around
$1.20 to below $1.09. The euro hit a low of $1.03 in January
2017.
Euro zone manufacturing surveys last week were the most
recent to miss expectations - although so have some in the
United States - and a Reuters story on Monday on German economic
institutes preparing to slash German economic growth forecasts
again sent the euro hurtling lower. MARKET PRESSURES
Ructions last month in the U.S. "repo" market - a market for
short-term funding - may also explain why dollars are so in
demand.
Interest rates in the $2.2 trillion market for repurchase
agreements rose as high as 10% on Sept. 17 as demand for
overnight cash from companies, banks and other borrowers
exceeded supply. Banks and investors called it the most serious disturbance
in the U.S. money markets since the 2008-2009 financial crisis.
While the jury is out on the significance of the spike in
repo rates, concerns about a shortage of short dated
dollar-denominated funding have increased.
Demand for offshore dollars has also grown sharply,
according to cross-currency basis swaps, an agreement in which
one counterparty borrows one currency from another institution
and lends the same value in a different currency.
RATE EXPECTATIONS
And then there is the relatively high yield investors earn
on U.S. government bonds versus those in the euro zone.
While the Federal Reserve has launched a rate-cutting cycle
this year, so has the European Central Bank, and expectations
are that U.S. rates will remain far higher than other developed
markets for the foreseeable future.
Money markets on balance expect a 25 basis point rate cut to
the current Fed rate of 2% in October, but that would still
leave rates far above the -0.6% of the euro zone.
Overnight index swaps in the United States all yield more
than 1.5% out to a 1-year maturity.
CESI and EURUSD https://tmsnrt.rs/2oPUcz7
USD EUR indexes https://tmsnrt.rs/2oNjtKi
Money market pressures and DXY https://tmsnrt.rs/2o5JSms
Money market expectations png https://tmsnrt.rs/2ncSuaV
US overnight repo and libor-OIS spread https://tmsnrt.rs/2oaMX4M
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