Dollar Dilemma Du Jour

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About: Invesco DB USD Bullish ETF (UUP), UDN, USDU
by: The Heisenberg
Summary

Trump's policy proposals have propelled the dollar just as the Fed is set to begin tightening.

More tightening in response to those proposals means more gains for the US currency.

That, in turn, could derail the new president's promises on trade.

It is to a certain extent gratifying to have one's published opinions on markets "validated" (if that's the right word) by subsequent research from the sellside and by articles out of respected (if mainstream) financial publications.

The risk however, is that one eventually becomes an echo chamber for oneself. I used to work for a publisher that did this on purpose. They had a kind of arm's length relationship with multiple other publishers of their ilk and they had a formula - a circular, self-referential routine for generating traffic. What we would do is publish something slightly scandalous and that something would then promptly be cited by a site with which we had a friendly relationship. We would then cite their cite and so on and so forth. By the end, it gave the appearance of a "story" that had been vetted and reported by multiple sources, when in fact the entire thing was manufactured.

Looking back on it, I despise the scheme and I'm glad I quit. But if you're not careful, you can inadvertently do the exact same thing with reputable sources even when you have no connection to them whatsoever. I'm starting to feel that way a bit with the whole dollar (NYSEARCA:UUP) shortage story which I began exploring last summer and which has since become increasingly important just as I knew it would once money market reform was actually implemented in October.

One thing I didn't know however, is that Donald Trump would win the White House. Had I even suspected as much, I would have pounded the table even harder on the dollar crunch as it would have been readily apparent that the billionaire's proposed tax reforms would likely exacerbate the USD shortage (see here and here for more). But there's another angle to this story which I've mentioned in passing and which the FT is out this morning exploring. At the risk of lending credence to charges that I'm seeking out stories to validate my own, I want to highlight a few excerpts here so you can see what I mean when I mention another side to the narrative.

See the thing you need to realize is that the Fed can't really afford to get behind the curve here. That means, as I mentioned early on Wednesday, that there's no room to "err dovish." That said, it won't be for lack of trying. The FOMC doesn't look ready (just yet anyway) to signal a quicker tightening cycle as they would have when past administrations have pursued growth friendly policies. Still, their hand will in all likelihood be forced (twice) in the new year by expectations for faster economic growth and rising inflation.

Do you know what more hikes mean for the already rising dollar? That's right, more momentum. Let's bring in FT:

Donald Trump railed against the effects of an overly strong dollar during the election campaign, warning about the damage it did to US companies' competitiveness. Unfortunately for the president-elect, his own victory on November 8 has proven to be a catalyst for an even more expensive US currency - in part because of stimulus plans Mr Trump is pursuing.

Since the election the trade-weighted dollar is up about 3.3 per cent. With the incoming administration advocating policies that would boost the budget deficit, something that could prompt the US Federal Reserve to accelerate its rate-lifting plans, analysts including William Cline, a senior fellow at the Peterson Institute for International Economics, see further currency gains ahead.

He estimates in a new research report that as of mid-November the dollar was overvalued by roughly 11 per cent, and argues that fiscal stimulus and associated interest rate increases risk yet further increases in the dollar.

Pledges to tackle the trade deficit were a central feature of Mr Trump's campaign: a September report by advisers Peter Navarro and Wilbur Ross, his nominee to be commerce secretary, claimed that eliminating the deficit would lead to a surge in growth - a notion heavily criticised by economists. Mr Trump warned of the damage from a high exchange rate: "It sounds good to say 'we have a strong dollar'. But that's about where it stops," he said at one point.

Some officials fear that with his stimulus and the surging dollar Mr Trump could be creating swings in exchange rates that would lead him to blame trading partners such as China or the EU, heightening the temptation to resort to protectionist policies.

I have to say - and I really mean this sincerely as opposed to in a derogatory fashion - that it would be just like Trump to inadvertently create a situation (i.e. a surging dollar) and then use it to promote some other part of his agenda (i.e. protectionist trade policies). Again, that's not an attempt to disparage Trump, it's just a kind of objective assessment of the new President's temperament.

Now that FT has set the stage, let's look at some commentary from Goldman on the interplay between the dollar and expected Fed hikes:

Our core view has been for some time that monetary policy normalization in the US has the potential to drive the Dollar much stronger. That view has been challenged at various times this year by dovish shifts from the Fed, when it repeatedly downsized the overall size of the hiking cycle. For us as Dollar bulls, it is not whether the Fed hikes or not at a given meeting that matters, but rather what kind of overall hiking cycle it communicates, given that this has a big influence on the front-end interest rate curve. This is why dovish revisions to the "dot plot" weighed on the Dollar at various points this year. Exhibit 1 shows the drop in the median number of hikes through end-2018 in the Fed's Summary of Economic Projections in the course of the year. They show that the March meeting in aggregate cut the hiking cycle through end-2018 by one hike, by an additional two-and-a-half hikes in June, and a further two hikes in September. Exhibit 2 gives the breakdown by year, showing that the June FOMC in particular was the crescendo of downward revisions, cutting one hike in 2017 and another 1.5 hikes in 2018.

Ok, so that was then, what's up now? Well, as noted above, there's simply no room for a "dovish err" and in fact, the market isn't pricing next year correctly (emphasis mine):

Looking forward to today's meeting, the hurdle for additional reductions is high, even before you take into account the prospect of fiscal stimulus in an economy that is operating close to capacity. This is because it would take six dots to move down the median number of hikes for 2017 from two to one, while it would also take six dots moving down for the 2018 median number of hikes to go from three to two. Exhibit 3 shows that this is a higher hurdle for 2017 and 2018 than in any previous meeting over the past year, i.e., there is "Less Room to Run" for the Fed to revise the overall size of the tightening cycle down.

All this should be seen against market pricing for the Fed, which in our view is still catching up with changed circumstances. Cumulative pricing from interest rate futures through end-2019. Cumulative hikes priced through end-2019 have almost doubled since 8 November, with 142bp in tightening now priced (compared with 73bp then). In delta terms, this sounds like a lot, but this ignores the fact that the starting point - the initial condition - was very low. The easiest way we like to illustrate this is to focus on cumulative hikes through the end of next year. The market is pricing 70bp in hikes, including the 25bp hike that with a very high degree of certainty is coming today. This means that, taking out the hike coming today, the market is pricing around one-and-three-quarters hikes for next year, which does not seem like much of a risk premium over the one-hike-per-year pace that we experienced in 2015 and are likely to see this year. Given that some kind of fiscal stimulus is likely, we think market pricing should be somewhere between two and three hikes for next year, not between one and two. In other words, there is still room for markets to reprice the Fed in a more hawkish direction, to say nothing of our US team's view, which is for a cumulative hiking cycle through end-2019 of 300bp.

So that, in a nutshell, is why one should expect the dollar to continue its upward trajectory.

If you believe FT, this will be a disaster for Trump who will be forced to figure out how to reconcile his own rhetoric on the USD with the consequences of his rhetoric on fiscal stimulus.

Oh, the irony.

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.