U.S. Dollar Rally Could Fizzle As Fed Rate Hike Euphoria Wanes

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The U.S. dollar index, or DXY, has skyrocketed since the beginning of October from the talk-up of a Fed rate hike.

A Fed rate hike and Trump’s surprise victory, as well as a Republican clean sweep, sparked a rally in the U.S. dollar and Treasury yields.

A rising U.S. dollar and Treasury yields will have negative impacts on U.S. exports and home sales.

Strength of the U.S. dollar beyond current levels is unsustainable since it would add downside risks to the U.S economy.

The U.S. Dollar index, or DXY, which is essentially the USD/EUR exchange rate, broke out in early October after Richmond Fed President Jeffrey Lacker, a non-voting member of the FOMC, said in a speech delivered to the West Virginia Economic Outlook Conference that the Federal Reserve should adopt a strategy of preemptive increases in the federal funds rate to avoid the emergence of a situation that requires more drastic action after inflation moves higher like it did in 1994.

DXY Technical Chart

Despite a sharp pullback in late October due to uncertainty in the U.S. presidential elections and the announcement by the U.K. Prime Minister Theresa May that she and her government will trigger Britain's exit from the European Union, Article 50, by the end of March 2017, the U.S. dollar resumed its rally following Donald Trump's surprise victory on November 9. The DXY is now bumping into a key technical resistance at 102.16, or 61.8% Fibonacci retracement, and may be in the near-term running out of a catalyst for a breakout move, after Fed Chair Janet Yellen told the U.S. Congress on November 17 that a Fed rate hike could come "relatively soon" as the data points to a stronger economy.

Wall Street now wants to see the Federal Reserve raise the federal funds rate target to 50 and 75 basis points at the December 13-14 FOMC meeting since the probability of a 25 basis point rate hike has surged to 98.2%, based on the CME Group 30-day Fed Fund futures prices as of November 28. Failure to do so is no longer an option for the Federal Reserve because the markets have already priced it in.

USD/JPY Exchange Rate Techncial Chart

The U.S. dollar rally, which was boosted by a technical bounce in the USD/JPY exchange rate at the 100 yen level and a sell-off in gold when traders moved away from safe-haven assets, could fizzle as the Trump victory and Fed Rate hike euphoria wanes. The rising U.S. dollar is unsustainable since it is a drag on the U.S. economy so if Trump's campaign promises for new stimulus plans were to be approved, the Republican-led Congress would have to be willing to tolerate higher deficits in the short-run.

JPY/USD vs Gold Technical Chart

Despite a recent sharp pullback, the Guggenheim CurrencyShares Japanese Yen Trust ETF (NYSEARCA:FXY) is still up about 6.77% year-to-date, while the SPDR Gold Shares (NYSEARCA:GLD), which tracks the performance of the price of gold bullion, is up 12.16% so far this year. Both the JPY/USD exchange rate and gold price, which show a positive correlation (+0.84) over a 200-day period, are oversold and are now traded near key technical supports, 0.00877 dollar per yen, or 23.6% Fibonacci retracement, and $1181.00 per ounce, respectively.

Rising U.S. Dollar is Unsustainable as it's a Drag on the U.S. Economy and Increases Economic Downside Risk

The fear of a Fed rate hike and the rising U.S. dollar have put upward pressure on Treasury yields, sending the yield of the 10-year U.S. Treasury Notes to a 52-week high of 2.36% on November 23, while the average interest rate on U.S. 30-year fixed-rate mortgages climbed to above 4% for the first time in 16 months. The worst might be yet to come as recent data released by the U.S. Department of the Treasury showed that China sold $83 billion worth of U.S. Treasury Securities between June and August and now holds about $1.157 trillion of U.S. Treasury Securities, at the end of September 2016. Saudi Arabia has also sold $30 billion worth of U.S. Treasury Securities since the beginning of the year, or about 25% of their holdings. If the trend continues, the 10-year U.S. Treasury yield could move even higher.

US Treasury Securities Held by China

Rising mortgage rates may have already hurt the U.S. housing market since the number of monthly existing home sales during the third-quarter 2016 was down 0.25% to 5.39 million units, compared to 5.40 million units during the same period last year, the first quarterly decline since the third-quarter 2014, according to data from the National Association of Realtors. In fact, growth in existing home sales has been decelerating since the fourth-quarter 2015 when the Fed raised the federal funds rate by 25 basis points in December.

While a strong dollar gives Americans more buying power for products made overseas, the appreciation of the dollar has a negative impact on U.S. exports of goods and services. According to the data from the U.S. Bureau of Economic Analysis, U.S. exports have been on the decline since they peaked at $597.8 billion in the third-quarter 2014. The data also shows that a decline in U.S. exports led to a severe downturn in the U.S. economy during 2000 and 2010.

U.S. Exports

Earlier this month, the U.S. Labor Department released another disappointing nonfarm payrolls report, showing a seasonally adjusted increase of 161,000 jobs for October that missed Wall Street economists' median forecast of a 175,000 gain. The U.S. unemployment rate declined to 4.9% in October, as the civilian labor force participation rate dropped slightly to 62.8%, meaning some 94.6 million Americans are not in the labor force. The number of people who are not in the labor force but want a job now, declined to 5.91 million in October from 6.09 million registered in September.

U.S. Nonfarm Payrolls

The Labor Department will release its November nonfarm payrolls report on Friday, December 2. The consensus expectations are for 175,000 jobs added, meaning total nonfarm payrolls in the fourth-quarter 2016 are estimated to grow an average of 1.52% year-on-year to 145.04 million, the slowest pace since the first-quarter 2013.

From a historical perspective, a Fed rate hike could add appreciable downside risk to the economy, which led up to the last U.S. recession from December 2007 through March 2009. In June 2004, the Fed began hiking the short-term rate from 1.0% to 1.25% when the U.S. real GDP growth rate stood at 4.21%. By the time the Fed raised the key rate by a quarter-percentage point for the last time in June 2006 to 5.25%, the GDP had already decelerated to 2.94%. The U.S. GDP growth rate continued to slide to 1.78% and to negative 0.29% in 2007 and 2008, respectively, fueled by a rapid rise in crude oil prices and sinking home prices.

The November 25 forecast by the Federal Reserve Bank of New York of real GDP growth in the fourth-quarter 2016 is 2.5%. Taking the latest Fed forecast into account, the pace of U.S. GDP 2016 annual growth could be about 1.57% year-on-year, the slowest compounded annual growth rate since the end of the deep recession in 2009. Based upon the past rate hike events during June 2004 and June 2006, U.S. GDP 2017 annual growth could fall below 1.5%, if U.S. dollar strength and rising Treasury yields persist.

Dollar Bulls Are Counting on Accelerated Fed Rate Hikes if President-Elect Trump Keeps His Campaign Promises

It was the Wall Street consensus before the U.S. election that a Trump win would ignite panic selling of the dollar and the buying of safe-haven currencies, according to Bloomberg. In fact, the November 8 Speculative Positioning report, or the Commitment of Traders, aka the COT report, released by the Commodity Futures Trading Commission, or CFTC, showed that there were 65,490 long speculative positions of U.S. Dollar Index futures, compared to only 13,341 short positions, as Democrat Presidential Candidate Hillary Clinton was leading in the polls a day before the election.

Trump's surprise victory and a Republican clean sweep on November 9 sparked the rally in U.S. dollar and Treasury yields on expectations that the new administration's economic stimulus plans, including a large tax cut and as much as $1 trillion in spending on infrastructure, would create faster economic growth. Dollar bulls hope that Trump's fiscal stimulus plans would drive inflation sharply higher, which may prompt the Federal Reserve to raise its benchmark interest rate in December and beyond.

Trump has outlined plans for a trillion dollar investment in infrastructure over ten years, which offers $137 billion in federal tax credits to private investors who want to back transportation projects. Trump's plan could face a roadblock by his own party, as some Republicans are not going to vote for anything that increases the national debt, which will soon surpass the $20 trillion mark. Even if Trump's fiscal stimulus is approved by the Republican-led Congress, the Fed could be expected to accelerate its interest rate increases to stop inflation, and those higher rates would create a negative feedback loop for private investment and the economy.

Sooner or later, it may be found out that such infrastructure investments do not always work out the way they're supposed to. In December 2008, President Obama said this,

We've got shovel-ready projects all across the country. And governors and mayors are pleading to fund it. The minute we can get those investments to the state level, jobs are going to be created.

In November 2011, the Congressional Budget Office concluded that the $852 billion President Obama stimulus package, known as the "American Recovery and Reinvestment Act of 2009", may have sustained as few as 700,000 jobs at its peak spending, from July through September 2010, and that over the long run it would actually be a net drag on the economy.


A Fed rate hike and Trump's surprise victory, as well as a Republican clean sweep on November 9 sparked a rally in the U.S. dollar and Treasury yields, which put selling pressures on the Japanese yen and gold. The dollar bulls' expectations are major economic stimulus plans, including a large tax cut and $1 trillion in spending on infrastructure that would create faster economic growth and enable the Fed to accelerate its interest rate hikes to stop inflation. Trump's fiscal stimulus plan, as is, could face a roadblock by his own party, as some Republicans are not going to vote for anything that increases the national debt, which will soon surpass the $20 trillion mark.

The hypothesis that the Fed could be expected to accelerate its interest rate increases to stop inflation may backfire, as those higher rates would create a negative feedback loop for private investment and the economy. In our view, a rising U.S. dollar and Treasury yields will have negative impacts on U.S. exports and home sales, while further strength in the U.S. dollar beyond current levels would add downside risks to the U.S economy, which is already growing at a rate less than 1.6%.

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.

Additional disclosure: I am long bullion gold coins as an investment.