Dollar, Euro, Stock Markets - Main Scenarios

|
Includes: FXE, UDN, UUP
by: Aloha Insight

Summary

The most likely FX scenario: The dollar will keep appreciating for some time, then the trend will reverse.

Less likely scenario: Long term dollar strength.

Unlikely, but possible: Dollar weakness, or EZ break up.

In my last two articles I have discussed relative attractiveness of the US and European equity markets. Apart from the development of valuation and corporate profits on both markets, there is one more issue to consider with regard to this topic (and international investment in general): FX market development and outlook. Should US investors decide to invest in European equities (or assets in general), the strengthening dollar would wipe out at least part of their profits (or it would increase their losses). Of course, the opposite holds for the investors from eurozone (EZ) buying US equities and assets. Their profits are boosted (or losses mitigated) by the rising dollar. And vice versa. I believe there are several relevant scenarios to consider now with regard to eurodollar:

  1. The dollar will soon start to depreciate against the euro and continue to do so for extended period of time. This scenario is rather unlikely at the moment, because it would require complete reversal of the current growth and monetary expectations in the US and eurozone. As suggested above, this scenario would be favorable for the US investors holding EZ assets, but would play against EZ investors holding US assets.
  1. Dollar will appreciate against euro, but the trend will reverse in not so distant future. This is the most likely scenario at the moment and I will elaborate on it below.
  1. We are in the first phase of a long term dollar appreciation against euro. I believe this is not the most likely scenario now, but it should not be ruled out. As I noted in my previous article, EZ has some serious design flaws and its economy still needs some structural reforms. I am not in the camp of those who believe the supply side reforms are the only thing needed in EZ now, and I believe current strategy of ECB is better than doing nothing. But putting it all together, it cannot be ruled out that long term monetary expansion will be needed and called for, because the root problems of EZ will not be addressed.

There is also a possibility that EZ economy may perform quite well in this cycle, but the US economy will perform even better. One sound reason for this scenario is based on the development of the potential growth in both economies - it is widely expected to be significantly higher in the US than in EZ.

  1. There is also a possibility there will be no euro in few years, at least not in the same form as we know it know. This is a more severe version of the previous scenario - EZ with its design flaws combined with political inflexibility may end up in exits and a break up. A different currency union may be created but here the number of possible future developments rises sharply. They all have one common feature, though. It is a strong dollar against most of the new (or actually old) EZ currencies.

As I have mentioned, the most likely scenario now seems to be short term dollar appreciation followed by (at least partial) reversal in the foreseeable future (2016, or 2017). We may recall that at the beginning of 2015 the economic surprises moved in favor of EZ economy. Now the currents shift more in favor of the US economy again. This means that the policy divergence between Fed and ECB is likely to stay - Fed will start with tightening in September, exit from QE in EZ will probably start to be discussed with increased intensity towards the end of the year.

In this basic scenario, we could therefore assume the dollar ascent will stop at about this time (perhaps close to parity) and then the eurodollar could possibly move sideways for some time. This development would be sped up by faster reflation in EZ (possibly „helped" by oil price development). I could actually simplify the whole thesis by pointing out that US economic recoveries usually take place earlier than euro-zone recoveries. In other words, where the US economy goes, EZ economy follows. The dollar then usually appreciates against the euro during a US economic recovery, then the trend reverses. This time may be different, if the structural forces prevail. Nevertheless, "this time different" is very dangerous formula on the market.

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.