How Long Can The U.S. Dollar Index Stay Buoyant Amid Slower Trend Growth Of The U.S. Economy?

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Summary

The U.S. dollar index is being supported by comments from Fed officials and market expectations for the federal funds target range at 0.75 and 1.0% by year's end.

The DXY is overvalued despite increasing uncertainty in U.S. economic fundamentals, such as decelerating GDP and nonfarm payrolls data.

The strengthening yen and gold, as safe-havens, continue to put selling pressures on the U.S. dollar.

The U.S. dollar index, or DXY, a weighted index of the value of the U.S. dollar relative to a basket of six major currencies, pulled back sharply in late July after the U.S. Federal Reserve concluded its two-day FOMC meeting on July 27 and decided to maintain the target range for the federal funds rate at 0.25 to 0.50%. In a policy statement released after the meeting, the Federal Reserve said it has increasing confidence in the improving labor market and the ability for inflation to move toward its 2% annual target, while "Near-term risks to the economic outlook have diminished".

DXY Technical Chart

The Federal Reserve sees the federal funds target range at 0.75 and 1.0% this year, according to the FOMC participant's assessment, also known as the Fed's "Dot-Plot", meaning two more rate hikes are possibly on the table until December.

The DXY continued plunging after the market received a big surprise with the release of the second-quarter GDP (advance estimate) by the U.S. Bureau of Economic Analysis two days after the FOMC meeting, showing a disappointing GDP of 1.2%. So far this year, the U.S. economy is growing at about a 1% annual rate, the worst first-half performance since 2011. GDP growth was revised down to a 0.8% pace in the first-quarter, from 1.1%. Growth also was revised downward for the fourth-quarter of 2015 to 0.9%, from 1.4%.

The U.S. dollar index broke down the ascending channel chart pattern on Tuesday after the overseas market interpreted comments from President of the Federal Reserve Bank of San Francisco John Williams as dovish, in his economic letter posted on the bank's website earlier on Monday.

In the letter, Williams said,

Although targeting a low inflation rate generally has been successful at taming inflation in the past, it is not as well-suited for a low r-star (natural rate of interest) era. There is simply not enough room for central banks to cut interest rates in response to an economic downturn when both natural rates and inflation are very low.

Williams also proposes raising the Fed's current 2% inflation target, or replacing its current inflation-targeting regime with some form of nominal GDP targeting. In addition, he also called for changes to fiscal policy, perhaps tying tax rates or government spending to unemployment rates.

In our view, the U.S. dollar index has been in tight range between 93 and 98 since February of this year, despite increasing uncertainty in U.S. economic fundamentals. The index is being supported by hawkish comments from some Federal Reserve officials and market expectations for the federal funds target range at 0.75 and 1.0% by the end of this year. The dollar index should break down after the majority of FOMC's participants are convinced that the U.S. economy is in deceleration, or slower trend growth, and the current federal funds target range is no longer appropriate.

U.S. Dollar is Overvalued as Uncertainty Rises in U.S. Economic Fundamentals

The International Monetary Fund, or IMF, said on June 22 that the U.S. economy was "overall, in good shape,", but decided to revise downward the growth forecast to 2.2% in 2016, after subpar GDP growth of 2.4% in 2015. The core personal consumption expenditures, or PCE, index, excluding food and energy, the Federal Reserve primary inflation gauge, is expected to rise 1.8% in 2016, compared to a 1.4% gain last year, said the IMF.

The IMF also said in a released statement that, "At today's levels of the real effective exchange rate, the current account deficit is expected to rise above 4 percent of GDP by 2020, pointing to the U.S. dollar being overvalued by 10-20 percent." From the IMF's view, the U.S. dollar index should be in the range between 77 and 86 to warrant U.S. economic conditions.

The U.S. GDP has had slower trend growth since the third-quarter 2014, and was particularly lackluster in the fourth-quarter 2015 through the second-quarter 2016. The economic outlook is not getting better, as the Federal Reserve Bank of New York just trimmed its U.S. GDP forecast for the third-quarter of 2016 to 2.4% from the previous 2.6%, after the U.S. Commerce Department reported mediocre retail sales for July. A warning sign for economists is that Americans are cutting back on discretionary spending, despite low unemployment.

US GDP

According to the Department of Labor, the total seasonally adjusted nonfarm payrolls, as of July 2016, stands at 144.448 million. If 220,000 jobs are added for August and September each, total seasonally adjusted nonfarm payrolls growth will be 1.77% for the third-quarter 2016, the slowest since the second-quarter 2014. Slow growth could be due to various factors, including lack of available and qualified workers, as the labor market approaches maximum employment.

U.S. Total Nonfarm Payrolls

Nonetheless, with the current unemployment rate of 4.9%, the Federal government needs to create over 700,000 jobs a month, according to the Atlanta Fed's "Jobs Calculator", to achieve a labor force participation rate of 66%, the level seen prior to the 2009 recession. Hence, maximum employment is just an illusion when the labor force participation rate now stands at 62.8%, near a 38-year low.

Growth of U.S. total seasonally adjusted nonfarm payrolls has declined steadily since the second-quarter 2015, while hourly wages inched up 3.13% from $24.91 per hour in April 2015 to $25.69 per hour in July, or about 2.35% on an annualized basis, despite a rise in minimum wages in some states and cities. Core PCE climbed from 109.25 in April 2015 to 111.24 in July 2016, an increase of about 1.37% on an annualized basis. In fact, core PCE has been running below the Federal Reserve's inflation target of 2% since second-quarter 2012.

Strengthening Japanese Yen and Gold Prices Continue to Put Selling Pressures on the U.S. Dollar

Concerns about the weakening U.S. and global economies, the Bank of Japan's, or BOJ's, negative interest rate policy, as well as the Brexit vote aftermath, have put buying pressures on the Japanese yen and gold as safe-havens and selling pressures on the U.S. dollar. The recent Japanese Prime Minister Shinzo Abe's cabinet approval of a 13.5 trillion yen ($132 billion) government stimulus package, which includes 7.5 trillion yen ($73 billion) in new spending to jump-start Japan's sluggish economy, sent the Japanese yen surging against the U.S. dollar as the market is skeptical whether the stimulus will work. Most economists predict the stimulus will only modestly increase economic growth and could just pile up more debt without really boosting long-term growth.

JPY/USD and Gold Correlation

The JPY/USD exchange rate and gold price, which show a positive correlation (+0.9) over a 100-day period, have been on the rise since December last year, while the USD/JPY exchange rate and the yield spread between the 10-year and 2-year U.S. Treasury Notes, which also show a positive correlation (+0.78) over a 100-day period, have been on the decline since early 2015. Narrowing spreads may indicate worsening economic conditions in the future, resulting in a flattening yield curve. A very low or negative spread could signal an upcoming recession. Since 1960, each time that the yield spread went negative, a recession followed approximately 12 months later.

USD/JPY and 10-2Y Spread Correlation

From our technical viewpoint, the USD/JPY broke through the 100.67 support, or the 50% Fibonacci retracement level, for the third time this year on the recent comments from the Fed's Williams. The currency pair could pull back further to retest the June low at 99.08. In a note published in the Financial Times on June 17, Alan Ruskin, the New York-based Global Head of G10 FX Strategy at Deutsche Securities, said the BOJ would likely step in if the dollar "threatened or breached" the 100 yen level.

USD/JPY Technical Chart

Former Japanese Vice Finance Minister Eisuke Sakakibara, also known as "Mr. Yen", believes that the yen could strengthen towards 90 per dollar as soon as this month, and sees the "intervention zone" lying between 90-95, when dollar weakness should worry the U.S. Treasury Department enough to agree to yen selling by the Finance Ministry, according to Bloomberg. Mr. Sakakibara's assessment seems to contradict the U.S. Treasury Department, as it issued a stern warning in May against any action by the Japanese government to weaken its currency because there should be no disorderly trading in the yen that would justify intervention.

A yen intervention by the BOJ won't work when the USD/JPY exchange rate and the yield spread between the 10-year and 2-year U.S. Treasury Notes are directly correlated, as currency traders will sell the U.S. dollar and buy yen when the U.S. Treasury yield spread is narrowing. The last intervention by the BOJ was in August 2011 when the bank sold a record 4.5 trillion yen and bought U.S. dollars, causing the yen to tumble temporarily. But a week later, the currency was back above its levels before the intervention.

Gold Technical Chart

As demand for gold as a safe-haven asset continues, more selling pressure will be put on the U.S. dollar. The gold price bounced off its December low of $1,045.40 per ounce and broke out the bullish descending wedge chart pattern in February. Gold has now broken out the 38.2 Fibonacci retracement level, at $1285.57, and is bumping into the trendline resistance at 1,358.70. If the yen continues to gain strength, gold could follow and head to the $1,430 resistance level, followed by the 23.6 Fibonacci retracement level at $1,529.46.

Conclusions

The U.S. dollar index has been in tight range between 93 and 98 since February, despite being overvalued amid increasing uncertainty in U.S. economic fundamentals, such as decelerating GDP and nonfarm payrolls data. The index is being supported by hawkish comments from some Fed officials and market expectations for the federal funds target range at 0.75 and 1.0%, meaning further rate hikes by the end of this year.

The dollar index may break down after the majority of the FOMC participants are convinced that the U.S. economy has slower trend growth and the current federal funds target range is no longer appropriate. In addition, global concerns have strengthened the yen and gold as safe-havens, which continue to put selling pressures on the U.S. dollar.

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