The following article is my logic in supporting a long position in the Dollar vs both the EUR and GBP. I will touch on employment, the services sector, energy production, and QE.
The first and obviously most significant of these is the improving economic picture in the US. While we can argue about the extent of this recovery, progress is apparent. With ISM Manufacturing Index numbers improving for the last several months, as well as an improving employment picture it is clear that the economy is picking up some amount of steam.
Source: Federal Reserve Bank of St. Louis (research.stlouisfed.org)
I'll start with the unemployment picture, which is widely understood to be improving. While the case has been made that the rate of improvement in the job market isn't improving, the overall unemployment rate is getting closer to the Fed's goal. I will refrain from reading into the most recent December numbers regarding employment and Labor Force Participation as seasonal ambiguities have been cited. Gains have also been visible in employment service stocks, implying some steam and confidence in the job market. The Standard & Poor's Supercomposite Human Resources & Employment Services Index has risen 19% since October.
The improving employment picture obviously suggests an improving economic landscape in the US and, thus, a stronger dollar. However, I believe that a look at services sector employment and the demographic shift associated with it also suggest an appreciating dollar. While the most recent ADP figure showed manufacturing and service sector growth about equal, I see services sector growth accelerating as a result of the aging Baby Boomer population. Expected growth in the Health Care sector and elsewhere should create this occurrence. As services increase as a percentage of GDP the demand for the dollar should increase due to falling demand (in a relative sense) for imported goods. Factset data shows about .5% growth in services employment over the last two years (Factset Research). Combined with improving employment I believe these numbers could rise modestly on a 12-month horizon and (again) may be worth considering in equity opportunities, but I digress. While the ISM Services Index took an unexpected dip, I have little concerns of this single data point over a year outlook. The International Trade Administration says that in 2010 70% of output came from the services sector (this number has increased since) and despite improving PMI numbers I don't see this number wavering.
Switching gears, I'll now attempt to shed some light on QE and tapering. As $10Bn fewer dollars are added to the economy every month the obvious point is the impact on money supply. Based on Factset data, I believe we could see December and January M2 figures increasing below 6% YoY for the first time in 12 months (Factset Research). While it isn't necessary to explain that lower supply implies appreciation there is a secondary impact that comes from the treasury market.
QE as an economic climate indication is one clear benefit, but it comes with rate divergence against the rest of the globe (to benefit the dollar). As treasury yields creep up the dollar should draw in more foreign buyers. I will play devil's advocate here though: fund flows into equities have largely been assumed to be into US equities, however Credit Suisse published research suggesting that US equity flows have remained about constant and that the majority of equity flows have been into European equities. How to interpret this is up to you, but is noteworthy. Nevertheless, rate divergence should create appreciation of the USD.
**Tangentially, I'd like to mention that while it is obvious that the US has a more attractive economic landscape than Europe, the key consideration in Europe is that the issues there are much more structural and will require a much longer time to adjust or "fix". This is important in considering how the USD will move in relation to the EUR, but I think is more important to the GBP than USD.
I would also like to highlight, very briefly, the US energy boom. The US is on its way to energy independence and the impact of this on the dollar should be clear. However, this topic is widely discussed and so I will refrain from discussing any further. I would like to point out the pressure of allowing US oil exports and the impact this would clearly have on the USD. In any case, lower dependence on oil from OPEC countries improves the trade deficit and indicates a stronger dollar. The graph below, from the Energy Information Administration, shows the acceleration of US crude production and does a good job summarizing the shale revolution.
Source: US Energy Information Administration
In short, a stronger manufacturing base no longer needs the dollar to continue be weak to support exports. Our trade deficit will also continue to benefit from domestic oil production. This is aided by the fact that services in the US will continue to increase in demand due to a generational shift. I recommend being long the USD vs both the EUR and GBP with more conviction against the EUR. While I hold no positions in either, I like the PowerShares DB US Dollar Index Bullish Trust (NYSEARCA:UUP) and would sell the CurrencyShares Euro Trust (NYSEARCA:FXE).