Four Reasons Why The Dollar Rally Is Nowhere Near Over

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Technical consolidation has ended.

Reason 1 - The Fed will act in December.

Reason 2 - Interest rate differentials favor the greenback.

Reason 3 - A new political direction.

Reason 4 - New trade deals.

In May 2014, the nearby dollar index futures contract made a significant bottom at 78.93. The U.S. currency never looked back from that low and the dollar exploded higher, rallying to 100.39 by March 2015, an increase in value of over 27% in just ten months. It was a fantastic rally for a currency. Foreign exchange instruments, particularly the world's reserve currency, rarely move to such an extent on a percentage basis. However, quantitative easing was coming to a close in the United States and the Federal Reserve signaled to markets that it could not be long before short-term interest rates would begin to "lift-off" from zero.

The central bank policies of QE and low interest rates were a battle against lethargic economic conditions in the world following the global economic crisis of 2008. Governments employed these policies to inhibit saving and encourage borrowing and spending to stimulate economic conditions. As the U.S. economy began to show signs of increasing economic growth and a decline in the unemployment rate, the need for the emergency measures declined. However, in Europe and Japan, conditions remained in place for a continuation of central bank stimulus. In Europe, a vast humanitarian crisis that continues to bring immigrants to the continent has diluted economic conditions and caused unemployment, particularly in Southern Europe, to remain high. In Japan, an aging workforce has caused productivity to decline and the need for social programs to support the growing number of citizens who are not in the workforce has weighed on the economy.

Starting in May of 2014, signs of improving U.S. conditions when compared with other major nations around the world caused a repricing of the dollar when compared to other major foreign exchange instruments.

Technical consolidation has ended

On November 17, the nearby dollar futures contract traded to the highest level since 2003. Source: CQG

As the weekly chart highlights, after March 2015 the dollar managed to make a marginally new high in November 2015 at 100.60 but it traded in a range from that level to lows of 91.88 over a period of around twenty months. The first leg up in the U.S. currency took it 27% higher in nine months, now after a long period of consolidation it looks like the greenback is at the start of its second leg higher in a multiyear bull market.

There are four reasons why I believe that the dollar is just beginning to move higher. The dollar is the reserve currency of the world and it is the benchmark pricing mechanism for raw material prices. Therefore, a stronger dollar will have a critical influence on markets across all asset classes in the months ahead.

Reason 1- The Fed will act in December

The U.S. Federal Reserve increased the Fed Funds rate in December 2015 for the first time in nine years. At that time, they told markets that the "lift-off" from zero was the start of a tightening cycle and to expect 3-4 more rate hikes in 2016. However, it is now the end of November and the central bank has not moved short-term rates remain at the same level they were almost one year ago.

There are many reasons why the Fed has not acted in 2016. All the while, the central bank has been watching economic data. Employment data has been positive, the official unemployment rate is at 4.9% and there are some signs that wages are increasing. Additionally, economic growth remains moderate so the Fed and markets are ready for the first rate hike of the year at the upcoming December meeting. Meanwhile, many Fed officials had signaled that rates would rise in December as early as August when Vice Chairman of the Fed Stanley Fischer and others said that a hike was "imminent". Even though the central bank has not acted, it is likely that they waited for the election. The market is virtually unanimous in their expectations for a 25 basis point increase in the Fed Funds rate at the least meeting of the central bank in less than one month.

A higher short-term rate comes after the bond market turned lower starting in July. However, the Fed move and any signal that they will pick up the pace when it comes to rate hikes in 2017 will be supportive for the dollar.

Reason 2- Interest rate differentials favor the greenback

In the world of currencies, the dollar has not real competition these days. Europe continues to face economic problems. The ECB will likely extend its quantitative easing program when it expires in 2017. Additionally, European rates remain in negative territory. Japan is facing the same issue with the short-term rate at negative 40 basis points.

It is hard to argue against the dollar when its yield is higher than other competing currencies and its trend is higher. One of the most influential factors in determining foreign exchange rates if the interest rate differentials between currencies. The bottom line is that there is already a strong argument for holding dollars when compared to euros or yen. Higher interest rates in the U.S. increases those differentials and makes a strong argument a compelling case.

Reason 3- A new political direction

The U.S. is the leader of the free world. However, this year the nation followed the United Kingdom's lead in shocking markets. In June, the vote to exit the European Union took pollsters and market pundits by surprise. It now appears that the vote in the U.K. was more of a desire for change and a rejection of globalism around the world than an isolated event. On November 8, the U.S. elected an outsider as the forty-fifth president of the nation. President-elect Donald J. Trump won a close contest with an electoral vote majority campaigning on making America first. One of the major themes of the campaign is his intention to rebuild infrastructure in the United States.

Central banks around the world have often said that monetary policy alone is not enough to stimulate economic conditions. The biggest infrastructure building program in the U.S. since the Eisenhower Administration will create a huge injection of fiscal stimulus. It is likely that economic growth will increase in the U.S. as the new president will watch his legislation sail through both Republican houses of Congress with little or no opposition. Fiscal stimulus will cause the rate of inflation to rise, economic growth to accelerate and short-term interest rates to start increasing at a much faster pace. The central bank is likely to be very busy increasing rates in 2017 and any new appointments will reflect the more conservative nature of the Trump Administration. All of these factors are bullish for the U.S. currency.

Reason 4- New trade deals

Finally, another promise from President-elect Trump will cause the dollar to continue making new highs. During the long and contentious campaign season, the incoming leader said that the U.S. needs to renegotiate trade agreements to make terms more favorable for the nation. He often said that those receiving military protection from the U.S. need to pay their fair share. If the new president can make good on promises to create trade deals and military protection arrangements that favor the U.S., to any extent, it will likely cause the dollar to strengthen against other currencies around the world.

President Donald J. Trump is like no other leader in our lifetime, perhaps in history. Winning is everything to this leader and he may use the dollar as a benchmark for his success. Most U.S. governments adopted strong-dollar policies but for the incoming administration the dollar may turn into a scorecard on the success of the president on the world stage.

I am very bullish on the prospects for the dollar over the coming years. Source: CQG

The monthly chart of the U.S. dollar index shows that the next significant area of technical resistance for the dollar is at just under the 110 level, the 2002 highs, after that 120 comes into play on a technical basis. The dollar has a lot going for it these days. It appears that the days of monetary stimulus have ended and a new era of fiscal spending and increasing economic growth could be on the horizon. Interest rate differentials support a higher dollar.

I expect lots of volatility in markets across all asset classes in the weeks ahead as the U.S. settles into and gets comfortable with a new administration. However, the breakout in the dollar is real and the second leg up in a bull market that started in May 2014 is already underway. The rally in the greenback is nowhere near over.

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