Medium-Term Bullish On USD

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 |  Includes: UUP
by: FX Analyst

Summary

Consistent US economic recovery continues its steady positive momentum.

Weakening of the stock market is more due to end of easy money than perceived weakness in the market or uncertainty over the sustainability of the recovery.

Asset reallocation after expected Fed Hikes in Q1 2015 better explains recent stock declines than weakness in the US economy.

Medium-term bullish on the USD based on expected higher rates and strengthening economy.

The US reported a series of high impact positive news last week starting with the annualized Gross Domestic Product (GDP) of 4.0% in the 2nd Quarter of 2014, far better than the expected 3.0% and the previous quarter of -2.1% decline. There has been 6 consecutive quarters of increased non-farm payrolls above 200,000 with this current print of 209,000. Although the pace has not accelerated to what the market has expected, the pace has been steady. This confidence has resulted in the increase of personal consumption from 1.2% to 2.5% in Q2 2014.

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This confirmed that the previous quarter weakness in GDP is a result of the bad weather (harsh winter) and time for the inventory to work off. In fact the US ISM Manufacturing report showed that PMI has expanded for an impressive 12 conservative months with the latest acceleration from 55.3 to 57.1 in July 2014.

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The Fed remains cautious as it sees additional slack in the labor market as the US unemployment rate ticks up from 6.1% to 6.2% as more encouraged workers re-entered the labor market in search for jobs. It has maintained its planned tapering by reducing its treasury purchase from $20B to $15B, MBS Purchase from $15B to $10B and kept its overnight rates unchanged at 0.25%.

On the background of such a favorable outlook, the stock markets lead by the S&P 500 (NYSEARCA:SPY), declined substantially last week. This led some observers to speculate that this is a false recovery. On the contrary, the market's decline reflects the market's realization that this recovery is real and that at some point the Fed is going to normalize its interest rates from its current 0.25%. The realization that we are nearing the era of easy money is finally hitting home more clearly now. We are now seeing the early stages of a reorientation of investment strategy to reflect this new normal.

The low interest rates have forced savers even the conservative ones into risky stock markets to earn a return higher than inflation. The market now expects the Fed to raise its interest rates earlier by Q1 2015 instead of Q2 2015. This expectation of rate hike has lead to the initial stages of a reallocation of assets away from equities into other asset classes such as fixed income that is more suitable for their client's risk appetite.

The expected rate hikes should encourage foreign inflows into fixed income assets, which would be bullish on the USD (NYSEARCA:UUP). After the weak longs have been shaken out of the stock market, it will be attractive to new investors who would see the recovery as sustainable and pour fresh funds into it. Overall we are bullish on the USD over the medium term.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.