March FOMC Unveils A Dovish Fed Reaction Function, But Fundamentals Still Favor The U.S. Dollar Nonetheless

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Includes: DIA, IWM, QQQ, SPY, UUP
by: Robert P. Balan

Summary

US Dollar weakness after the March FOMC more likely reflect a dovish Fed communication instead of a core negative response to significant improvement in the global macro sentiment and inflation.

Despite the current benign market view of the US tightening cycle post-March FOMC, US-G7 rate differentials have become favorable again for the US currency, suggesting limited scope for further USD weakness.

What this means to hard assets is unambiguous. The initial enthusiastic surge in commodity prices and EM assets since February will likely be “retraced” and some gains likely given up.

All these suggest that the time to pile into hard assets should be sometime in late Q2-early Q3. But some initial long positioning could be done within a few weeks.

It has become harder for the financial markets to interpret the Federal Reserve's reaction function to economic and activity data after the widely-perceived volte-face during the March FOMC meeting. The subsequent US Dollar weakness after the meeting more likely reflects a dovish Fed communication instead of the US unit's core negative response to significant improvement in the global macro sentiment, if not in actual global activity (positive surprises in China), and in an inflation surprise pick up on a global scale (see chart below), which may soon help neutralize the deflationary impulse that has gripped global finance. A global economy with a higher inflation bias tends to work against the US Dollar valuation in the longer run, but we do not believe that this issue is playing a part in the US Dollar's current weakness.

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Concerns about the global and US economy were key components of Fed Chair Yellen's dovish message - a theme that has been echoed by central bankers in the Eurozone and in Japan, who are still looking for novel ways to kick-start their economies. All of these present issues to the analysis as to the course of the US Dollar in the short-to-medium term, and requires a more nuanced view, since the US Dollar's valuation is not an independent variable, but paired with the valuation of other currencies.

Ms. Yellen's dovish speech felled the US Dollar - but not for very long

The recent speech of Chair Janet Yellen reiterating a more dovish view still holds the US currency in thrall, and so we expect the US dollar to continue its current downward course - but not for very long. Despite the current benign market view of the US tightening cycle post-march FOMC, US-G7 rate differentials have become favorable again for the US currency, suggesting limited scope for further USD weakness, in our view.

Put into a temporal frame, the US Dollar weakness against the major currencies may last just for one month, or even less. FX fundamentals, which have previously weighed on the US currency (causing almost a year of sideways consolidation) have now reversed, and should favor the greenback over the next few months. We put our case for a stronger US Dollar in the near term in the discussions that follow.

Case 1. Annual inflation rates (which have a direct impact on central banks' inflation function) are again favoring the US currency, unlike in recent months. The US-EU GDP spread is also starting to turn in favor of the USD. See that in the chart below:

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Case 2. Against the Yen, both the GDP growth spread and the 2-year yield spread now favor USD against the Japanese currency, after a few months of the USD at a discount in the fundamentals: See the chart below:

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So fundamentals again favor the US Dollar against the JPY and the EUR. Nonetheless, we acknowledge that after Ms. Yellen's speech last week, there is now a higher bar for future rate hikes. And it will now take a longer series of positive US economic data surprises before the financial markets regain faith in the "strong-USD theme." The March FOMC policy minutes (due for release this coming Wednesday) should add more clarity on the Fed's recent thinking. However, the near-term trajectory of the US unit is also dependent on factors that impact its major G-7 competitors.

We note that the Fed is not the only central bank with concerns about risk factors, internal and external. The proof is provided by the Developed Economies' fixed income markets (especially in Europe and in Japan), which have remained strong year to date, pricing in rising concerns about lower potential growth and disinflationary pressures in those areas (and short-term rates had in fact gone to negative in the eurozone, see chart below). Those super low rates compare unfavorably with the higher average short- and long-term rates that can be obtained in the US.

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Some of the Fed's recent concerns about US domestic activity will likely be echoed by other major central banks in coming months regarding their own domestic activity (at a more urgent degree). For instance, the ECB is looking into widening the scope of their quantitative easing program. And the Bank of Japan is looking into the feasibility of going further negative in their policy rate regime. Based on rate and growth differentials, the US Dollar should rise against the JPY and the EUR again. This of course implies that any further USD weakness in the near term is limited, in our view.

Case 3. And then there is the dynamic between the US Dollar and US interest rates. We know that in many cases, the Federal Reserve, among global central banks, sets the pace in monetary policy changes - and that is certainly true in the current cycle. This naturally creates an interval when the change rate of interest rates in the US have risen ahead of the changes in its global counterparts (as in late 2015, even before the Fed initially raised policy rates in December 2015). That works to raise the valuation of the US Dollar (as we saw in Q1 2016) and its positive impact tends to peak and then wane 3 to 4 quarters later. This tendency seems to be in effect at this time, and so we would be looking for a final USD peak over the next few months, as this regression chart illustrates, below.

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There will be a better time to reset long positions in hard assets

What this means to hard assets is unambiguous. The initial enthusiastic surge in commodity prices and in the assets in the EM space since February would likely be "retraced" and some of the gains would be given up. Nonetheless, we see a forthcoming "correction" as a "healthy" development from a price discovery point of view. The interim should also enable developments in China to improve further, building on the initial set of positive surprises seen in late March.

Positive surprises have been building up in the US and in the G-10, and are followed by a build-up of positive surprise in China two months thereafter - there will be a spate of positive "economic surprises" in China starting this month (see chart below) which would generally be favorable for hard assets, including base metals and other raw materials. A more stable China should stem further domestic currency outflows and should lessen the tendency for the US unit to appreciate.

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All these suggest to us that the time to pile into hard assets should be sometime in mid Q2 to early Q3 this year. Some initial long positioning could be done within the next few weeks, but the real time to pile into hard assets is during early H2 2016, in our view.

Disclosure: I/we 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.

Additional disclosure: The company the author represents may have outstanding long or short positions in the commodities discussed in the article. The company may also initiate new positions, long or short, in any of those commodities mentioned, within 72 hours of publication of this article.