What The Skeptics Are Saying About The Dollar Rally

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Includes: FXY, UDN, UUP
by: Kathy Lien

We have made it clear that we like the U.S. dollar and think USD/JPY is headed for a break of 103 and the EUR/USD down to 1.28. However, there are many skeptics out there who argue that the dollar doesn't deserve its current valuation, let alone further gains. Their reasoning has some merits, and eventually we believe that the dollar rally will lose momentum. But if there's one thing we have learned about the FX market, it is that currency moves can become more exaggerated and out of line with fundamentals than most people would anticipate. When the optimism reaches a peak, that's when the moves will reverse. And when that occurs, the correction can be brutal.

There are a few arguments floating around about why the dollar rally will not last. Some people believe that the Federal Reserve isn't in a rush to taper asset purchases, and when it finally decides to do so it will not mean that it's headed for the exit. At the last central bank meeting, the Fed indicated that it is open to increasing or reducing stimulus based on incoming data. So what it may opt to do is slow asset purchases modestly, take a long break to see how the economy responds and then recalibrate as necessary. While this is probably an accurate assessment of what the Fed will choose to do, if it comes at a time when the eurozone is still in recession and the ECB is talking about increasing stimulus, it will still be positive for the dollar.

Other skeptics argue that the further the dollar appreciates, the more of a headache it provides for the U.S. economy. They are also absolutely right as a stronger currency presents headwinds for the export sector, but the U.S. is not a trade-dependent economy and can therefore handle a stronger currency better than other countries. The more direct implication of a strong currency is on inflation. A stronger dollar lowers price pressures, which would give the Fed the flexibility to delay changes in monetary policy until it feels as if the economy is ready.

Today's disappointing economic reports are some of reasons why the Fed may want to wait. This morning we learned from the industrial production and Empire State survey that manufacturing conditions deteriorated in April and May. Inflationary pressures also eased, according to PPI, and foreigners bought significantly fewer dollars in March according to the Treasury's International Capital Flow report. These reports serve as a reality check for investors who may have grown overly excited about the outlook for the U.S. economy.

It also raises some concerns about the sustainability of the improvements seen in April, but it is far too early to tell if this slowdown is broadly based because the Empire State survey was the only piece of data for the month May. Tomorrow's housing starts, building permits, jobless claims, and Philadelphia Fed survey will provide us with a deeper look at how the economy has been performing. While the arguments of skeptics have some merit, for the most part we still believe that the relative outperformance of the U.S. economy will keep the dollar bid.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.