Three down, and one to go, if you are counting quarters in 2018. The Fed has raised its benchmark interest rate range by another 25 basis points for the third time this year, and every analyst is on board expecting one more hike in December. The S&P 500 index continues to roll on, hovering at 2936, but with a keen eye on the 3000 plateau. Will anything stall this Bull market in its tracks before the end of this calendar year? Only a few are suggesting such a fate at this time, but the narrative has shifted a bit, and all eyes are upon the Almighty Dollar. It is the “fulcrum” for what happens next.
Even with another hike by the Fed, the general consensus forecast for the greenback for the remainder of the year is to dip roughly 1.9% or so in relation to its commonly followed index, but it has been nothing short of a rollercoaster over the past nine months, a rollercoaster that none of the so-called banking forex experts predicted. If you were to believe these folks, we would be staring at an index value of 90.0 by yearend. The revised forecast now would find favor with 92.5. The index currently rests at 94.5.
If we look back to January, the narrative then was as follows: “The consensus view heading into 2018 is that the U.S. dollar will continue weakening and may fall below the bottom end of its three-year trading range. With economic growth in the U.S. still strong relative to the rest of the world and the Fed potentially increasing the pace of its already steady monetary tightening in what is still the global market safe haven, a reversal toward sustained strengthening in the U.S. dollar should not be ruled out for 2018.” Yes, they hedged their bets and did not rule out a stronger USD, which has come to pass.
The Dollar and the S&P 500 have exceeded analyst expectations for the year. U.S. GDP growth is on target for a 2.9% figure for 2018, again a bit higher than analysts had originally forecast. Why the difference? It appears that no one put any stock in Trump and his cronies passing a stimulus tax and spending bill so late in the economic cycle. Well-respected economists have criticized these actions as nothing short of suicide, but the deed was done, the record-setting Bull market rolled on, but every analyst on the planet is predicting doom and gloom in the next 12 to 18 months.
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Why did the U.S. Dollar confound the forex experts?
As we have noted in the past, the foreign exchange market has thousands of moving parts. Trying to predict a specific exchange rate at a given point in the future is fraught with difficulty. The result of this mass confusion is that analysts put forward a narrative first of how they see the world economy panning out over the next year, then come in reverse to fill in and connect the dots. It is also a given that several caveats will be cited, thereby deferring any accountability for errors made in preparing the published estimates. In fact, this narrative and set of forecasts are updated every quarter.
When 2017 ended, the USD index stood at 91.5. The Fed had just raised the rates again in December and announced that there would be four more increases in 2018. The Dollar had already begun to fall from its 94 perch before 2017 had concluded, perhaps, due to the negative narrative that was emerging. It bottomed in February at 88.0, its lowest ebb since the end of 2015, but, as history shows, it went on a rampant rise to 103.8 just after 2016 ended. The global economy was floundering and commodities were suffering due to the inflated greenback, causing the Fed to balk and allow for a brief weakening period to occur. That period ended in February of this year.
Here is a snapshot of the USD index from that low ebb in February, up to the point just before the Fed announced its hike:
In 2017, a “sell-on-the-news” response followed, but since last week, the USD has actually broken through the 95 level once more. Trade wars and uncertainty are expected to weigh heavy going forward. Here is one bank analyst’s take: “We note that speculators hold a relatively extensive long positioning in aggregate in the USD versus the major currencies at present. The positive carry implied by widely supportive interest rate differentials make the USD an expensive currency to sell (or short) absent stronger incentives, however. We do expect the USD to weaken in the medium term, reflecting a negative alignment of cyclical (slowing US growth and the nearing peak in Fed policy), structural (rising fiscal and wide current account deficits) and secular (reversal in the long-term USD bull trend) factors.” Not that easy to comprehend, but down is the guess.
The Dollar seems trapped within tight boundaries since June. Upward pressure continues to come from central bank policy divergence and from an economy that keeps plugging along. The Emerging Market crisis that accelerated back in April fueled the Dollar’s rise, but most agree that something needs to break. For those of you that love a “Head-and-Shoulders” formation, it is difficult to ignore the familiar pattern in the above chart. There may be three shoulders on the left, and one and a half on the right, but if it holds true, then a descent to 88 is once again in the cards. If that were to occur, Trump would rejoice, as would commodity-laden emerging market countries. Curiously enough, bank analysts do see a major drop in the USD in 2019, perhaps, down to or below 88.
One thing is clear, however. With so many people holding long-Dollar positions, any sudden drop brought about by whatever reason would cause a short squeeze, the likes of which the world has never seen. In anticipation of such a rush for the exits, a slow unwinding of these positions could also support the forecasts that have been presented. Fear can cause many things to happen, but weak hands in the long-Dollar will surely begin to transition to the Yen, Euro, and maybe even Pound Sterling. Time will tell.
What other extenuating circumstances could influence the direction of the USD?
Any discussion of other “moving parts” would have to include the Fed, Europe, trade negotiations, Emerging Markets, and China, although some include it in the EM sector. The recent moves by the Fed could normally be termed as tightening from a monetary perspective, something that could drive emerging market capital flight over the edge, but these short-term rate adjustments do not seem to be impacting bank reserve positions.
A few analysts have done the research and checked the math, such that: “So far, with all the rate increases the Fed has made and a year spent reducing the size of the Fed’s securities portfolio, liquidity seems to be more than adequate in financial markets, and there is little pressure on commercial banks reserve positions.” The same holds true for reserves at global banks. Other quotes follow the line of, “The world is awash in liquidity. The world is not experiencing any shortage of liquidity”.
The financial press also made a big deal about the Fed dropping the word “accommodative” from its post-meeting statement. One analyst quipped that, “The truth is Fed officials dropped ‘accommodative’ not because they don’t want to use the word ‘neutral’ but because they, and Fed Chairman Jerome Powell in particular, are trying to get away from the idea that they precisely know where neutral is.” Suffice it to say that all committee members see interest rates as rising going forward, so in other words, the current level of interest rates is, by definition, accommodative.
And then there is Europe, the proverbial “one step forward, two steps back” region of the global economy. As well as several members perform, you can always count on others to offset any progress made. France is picking up, but Germany is slowing. Italy may be a powder keg: “European bond yields are being dragged higher by the new surge in Italian yields. Italy’ 10-year yield is up 11 bp at 3.40%. It was at 2.80% five days ago. The two-year yield is up 25 bp to 1.56%, more than twice the 71 bp that was seen five days ago. EC President Juncker rejected Italian Finance Minister’s arguments and warned of a Greek-style crisis.” There is always hope that Juncker could be wrong.
It is also good and bad on the trade front. NAFTA agreements have been finalized, but Brexit continues to drag on, with neither side leaping to a compromise. There is speculation that concessions may be made, but the question is when. As for Trump and his tariff threats, it appears that 25% is the target for China imports, but a Trump temper tantrum may still be in the offing, if chaos is his true modus operandi.
If there truly is excess liquidity, then absorbing the impact of a few failing emerging market countries, like Turkey or Argentina, should not pose a problem. As for China, the central bank has also opened the liquidity faucets to spur domestic development, if external reports have been accurate. Are the production engines revving up? Will demand for commodities spike again? You need only look to Australia for your answer. The Aussie has been in freefall since the latter part of January, hugging the lower Bollinger Band almost exclusively for the entire ride down. To date, the Australian Dollar has fallen from a height of $0.81 down to $0.71 and change. It is surely seeking a bottom, and, if bank forecasts are correct, perhaps it is forming one now.
Time rolls on. Another quarter has come to a close, and earnings season is ahead of us. The prevailing narrative suggests that the U.S. Dollar must weaken over the months to come, but do the forex experts have it right this time around? There are arguments on both sides of the issue, but a path to strength brings with it consequences that no one wants to accept – economic meltdown and a recession worse than the last one.
If the new narrative is to take hold, then a multitude of long-Dollar positions must unwind, a move that would most likely favor the Yen, the Euro, and the Pound. As always, timing is the next crucial question to debate, but these three currencies comprise over 83% of the USD index. As they move, so will the index.