Central Banks Outlook And Financial Markets Will Sustain The U.S. Dollar In H2 '16

| About: PowerShares DB (UUP)

Summary

We think that investors’ interest toward the U.S. dollar will increase over the next few months for the solid performance of the financial markets and the positive short-term economic scenario.

In our view the Fed Funds futures should continue to attach a close to 50% possibility of a 25bp rate hike before year-end.

By contrast, all other major global central banks should maintain an easing bias over the next few months.

We think the U.S. dollar could appreciate against the currencies against which it is most undervalued, according to the OECD's PPP.

We do not see a strong upward trend of the U.S. dollar against the euro as the EUR/USD is already undervalued by 15%.

Following the strong performance of recent years - the Dollar index rose 25% in the period January 2014-March 2015 - the US Dollar has remained almost unchanged over the first months of 2016. The Dollar index is now 3% below the historical highs reached in March and December 2015.

We think that investors' interest toward the US Dollar will increase over the next few months, pushing up quotations. We see two factors sustaining the greenback: the solid performance of the US financial markets and the positive short-term economic scenario.

Indeed, while at historical low levels, US government bond yields are significantly higher than government bond yields of the other major world economies. For example, the 10-year US government bond yield is 1.6%, against 0.006% of the 10-year German Bund and the -0.23% of the 10 year Japanese bond. Moreover, the 10 Italian BTP yield is 1.25%, despite a much higher risk profile. We think that both rising and falling US yield could increase foreign investors' interest toward US government bonds. Rising yield will widen the yield differential toward other government bond yields, despite the possible short-term loss, while falling yields could be interesting for the short-term capital gain.

Moreover, the US economic outlook is clearly better than the outlook of other major countries, despite some sign of uncertainty that we highlighted here. In the USA, all the recent economic data - i.e. labor market report, ISM manufacturing/non-manufacturing indices, retail sales - came out better than expected highlighting the good trend of the economy in Q2. Over the last week, new housing starts and building permits came out better than expected, showing the strength of the housing market. Also the NAHB index was in line with a continuation of the positive trend of the housing market over the next few months despite a slight decline.

Conversely, in Europe and UK the economic activity could weaken in H2 and in 2017 after the UK decision to leave the European Union, and in Japan a new fiscal stimulus package to boost the economy could be needed soon to revive economic growth.

In this scenario, the Fed is the only central bank in the G-10 that could raise rates in the coming months.

We expect the FOMC's monetary policy meeting on July 26/27 to be without major indications for investors. The Fed should decide to maintain rates unchanged and should not give any hint on the next few months' outlook. In our view the Fed Fund futures should continue to attach a close to 50% possibility of a 25bp rate hike before year-end until the release of ISM manufacturing index and labor market report in the week August 1st-August 5th.

By contrast, all other major global central banks should maintain an easing bias over the next few months, with the effect to make the interest rate differential more favorable to the US currency. In Europe, the Bank of England is widely expected to cut rates by at least 25 basis points in August, when the impact of Brexit on UK economy will be clearer, while the ECB could extend the QE from March 2017 to September 2017 during the autumn. Despite positive economic scenario, Swedish and Norwegian central banks are also expected to maintain monetary policy unchanged over the next few months (rates are at -0.5% and 0.5% respectively).

In this scenario, the US Dollar should continue to attract foreign investments, which should fuel upward pressure. We think the US dollar could appreciate against the currencies against which it is most undervalued: according to the OECD's PPP, it is undervalued by about 20% against the Swiss Franc, by 10% against the Norwegian Krone and the Australian Dollar, by 5% against the Swedish Krona and 3% against the New-Zealand Dollar.

We do not see a strong upward trend of the US Dollar against the Euro as the EUR/USD is already undervalued by 15%. Only a marked easing of monetary policy by the ECB or a stronger than expected tightening of monetary policy by the Fed could push the EUR/USD toward 1. Indeed, only in this scenario could the 2-year interest rate spread further widen and the ratio between Fed's and ECB's balance sheet decline. Both these indicators were very well correlated with the EUR/USD movements over the last few years.

The most likely scenario is that the EUR/USD will continue to remain in the range 1.08/1.15 in the coming months, even if we think that the next strong trend of the cross-rate will be on the upside as we explained in the article "The Next Big Move Of The EUR/USD Could Be On The Upside".

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.