I wrote a while ago that I thought the Dollar index would trade up to 92 (from 84 then). I still believe that the move can occur as recent action in the Dollar Index [DXY] has been bullish.
It appears, as the stock market is telling us, that the US economy is exhibiting rising growth and easing inflation trends. The CPI and GDP numbers do not reflect this yet but, given the current movements in the marketplace, I believe that they will. Based on my current models, it appears that CPI inflation pressures peaked in June and then again in August (at very similar levels). If this is indeed true, then the Feds’ hikes have evened out inflation. In effect, they have created a neutral environment.
The chart below shows the rate direction of the rate hikes over the past 6 years and my own CPI forecasting model which takes into account the core rate of inflation and real time market based instruments. As you can see, in 2000, the Fed took the hiking campaign one too many times and then paused. This caused the US economy to slow too much and by the time they realized the error of their ways, stock markets and commodities were on their way down. Flash forward to today and you will see a Fed that has hiked again past pricing needs, and paused, before they missed by being too tight. This time around, they have paused with rising growth. This is a neutral environment.
The weakness in commodities (which has put downward pressure on prices) has given the long end of the treasury curve a reason to rally as traders' price lower prices. Before, such a move would put pressure on the dollar but the story has changed; Now it is a story of rising growth and easing inflation. This is represented in the performance of the Nasdaq vs. the S&P 500 with the former lately outperforming the latter. (I believe that perhaps technology will now see expanding margins and growth).
This rising growth trend makes the trade and fiscal deficits look less challenging. In addition, if prices are moving lower and growth is moving higher, it benefits to hold US Assets because of this implicit gain involved.
A few other thoughts also support the rally in the dollar. One is the continuous, monotonous “vigilant on inflation” statement that each ECB member has uttered over the past week. At some point, any market begins to tune out such repeated words if the actions by the CB do not back them up.
Since the ECB did not raise rates a few weeks ago, what is to say they will next time? Also, there were some rumors out of the ECB indicating rates will have to move up to perhaps 4% in 2007 but the Euro did not flinch- not rallying on good news, but bearish. This is based on rising risks in “oil, wages and tax” which are risks to inflation, ECB Chief Trichet said Thursday morning. With oil prices falling, the ECB has adopted other risks to support their rising inflation outlook. But this will only go so far as the IFO, ZEW and this morning Industrial Production, have not exactly knocked the cover off the ball.
These thoughts all argue for a lower Euro vs. the USD, in addition to the technicals. Based on the very long term chart, a series of tops have been forming and if a downtrade occurs this month (past the 1.25 level), the Euro could be on target for the 1.175 area. This would support a significant bounce in the dollar index up towards the 92 level.
The GBP’s upward trend vs. the dollar, which has been supported lately by rising inflation pressures and local growth – in effect similar to the argument that supports the USD currently - appears to be over arguing for some moderation in the level of the pound vs. the Dollar. A collapse is unlikely as I expect the GBP to rally strong vs. Euro given the rate and growth differentials of the UK vs. the Eurozone.
One major risk to my outlook is how the Fed manages this growth and prices neutrality. If they get anxious and begin another hiking campaign, they may stall growth. This would be a very solid argument in favor of shorting the dollar. Do I believe Bernanke will allow such to occur? No. I think the Fed will support the market which, in turn, will support the dollar.
And don’t forget this one major fact. A rising dollar is much like raising rates. It helps the Fed. Thus, it is in the best interest of Bernanke to keep neutrality in check. With Fed support, the dollar should continue this bullish move higher thru the fall into next year.