Is Dollar Strength A No-Brainer In 2017?

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Summary

The technical breakout is bullish.

Interest rate differentials is bullish.

European elections and Brexit is bullish.

The new U.S. administration is still a question.

The move will be gradual because otherwise it will create problems.

Since November, the U.S. dollar has been trading at the highest level since 2003 and it reached highs on the dollar index at 103.85 in December, the highest since 2002.

The U.S. tends to operate under a strong dollar policy, but the caveat on that is that government economists and central bank and Treasury officials never want to see the dollar appreciate too quickly. In fact, those with their hands on the steering wheel of the U.S. economy or others around the world never want to see massive volatility in currency markets. The higher currency volatility, the more difficult it is to manage economies via monetary or fiscal policies.

The dollar has been in bullish mode since making lows on the index at 78.93 in May 2014 after years of consolidation against other currency levels. However, the first leg of the bull market took the greenback more than 27% higher in just ten short months. After the March 2015 highs the currency went back into consolidation mode but in November of last year, it began its second leg of the bull market in the greenback which now seems to be firmly in place.

The technical breakout is bullish

The dollar broke through technical resistance on the index during late November 2016. Source: CQG

As the monthly chart of the U.S. dollar index highlights, the greenback broke out in November and traded to highs of 103.815 at the start of 2017. Since then, the dollar has backtracked but it has yet to trade to the breakout level of 100.60 which is now the area of critical technical support. On the long term chart, the trend for the index and currency remains higher and the next level of technical resistance is at the September 2002 highs of 109.75. The dollar index was trading on Tuesday, January 10 at the 101.730 level so resistance is now around 7.9% above the market. Source: CQG

On the daily chart, the index has declined since reaching highs on January 3 with the momentum indicator, the slow stochastic, supportive of the correction. However, as the metric moves from neutral to oversold territory on the daily chart the chances are that it will once again reassert itself on the upside. The dollar index moved to a low of 101.295 on January 5 but so long as it remains above the 100.60 support level the bullish trend intact for the dollar.

Technicals support the dollar, but fundamentals for the greenback are even more positive at this time.

Interest rate differentials is bullish

When it comes to currency valuations amongst the major reserve currencies of the world, nothing is more important than interest rate differentials.

Last December, the U.S. Federal Reserve Open Market Committee hiked the short-term Fed Funds rate for the second time in nine years. The mid-point for the Fed Funds rate now stands at 63 basis points and the central bank guided markets that they intend to continue to gradually increase the rate in 2017 and the years ahead. In their statement following the December meeting, the FOMC told markets to expect three 25 basis point rate hikes in 2017. At 63 basis points, the Fed Funds rate is still at a historically low level.

Meanwhile, in Europe short-term rates remain at the negative forty basis point level and in Japan they are also in negative territory. Source: CQG

As the monthly chart of the euro currency shows, the euro is in a long term downtrend, falling from all-time highs of $1.5988 against the dollar in July 2008. Since then the euro has been making lower highs and lower lows against the greenback and is now trading at the lowest level since late 2002. The long-term chart also indicates a sustained downtrend in the currency. Source: CQG

The monthly chart of the Japanese yen shows a similar pattern and trend as the euro currency. The bottom line is that the dollar has been trending higher because of growing interest rate differentials between the U.S. currency and the other major world foreign exchange instruments.

Economic conditions in the U.S. remain supportive for more interest rate hikes in the months ahead while in Europe and Japan, lethargic economic growth and low productivity with high rates of unemployment mean that rates are not going up any time soon in those areas of the world. From an interest rate differential perspective, the dollar looks set to make additional gains against both the euro and yen. When it comes to Europe, 2017 could provide even more reasons for the dollar to appreciate against the European currency.

European elections and Brexit is bullish

The Brexit referendum in June 2016 was a serious blow to Europe. The departure of the United Kingdom, the second largest economy in the European Union, puts additional pressures on the E.U. Moreover, the negotiation of details for the exit of the U.K. will only occur in 2017 and a contentious divorce could lead to additional currency volatility in the euro and pound sterling. Moreover, the Brexit vote began a trend of rejection of the status quo when it comes to political parties in power all over the world. Brexit caused Britain to replace its sitting Prime Minister.

Brexit was the first shoe to drop and in its wake the U.S. rejected globalism by electing Donald J. Trump the forty-fifth President of the nation. In Italy, a December referendum spelled the end of the Matteo Renzi administration. This year, elections in German, France and the Netherlands, the three economic powerhouses of Europe could spell the downfall of the European Union. Incumbent parties will face a populous worried about immigration. Weak economic conditions across Europe could mean that one or more of the elections will follow the trend of the U.K. and U.S. The potential for a further weakening of the European Union is high and that will likely add to more weakness in the euro currency against the dollar.

The new U.S. administration is still a question

The latest up move in the dollar came after the election of the new President. On the campaign trail, the incoming leader of the free world pledged to renegotiate trade deals that he called "unfair" to the American people. Furthermore, President-elect Trump promised the biggest infrastructure building project in the nation since the Eisenhower Administration in the 1950s. The promise to rebuild America's roads, bridges, railroads, tunnels, airports and the construction of a security wall along the southern border of the nation amounts to a healthy injection of fiscal stimulus into the U.S. economy. With both Houses of Congress behind the next President it is likely that infrastructure spending legislation will pass through the legislature and we will see a pickup in GDP growth in the months ahead. As economic grow accelerates, the Fed will become more likely to hike rates further exacerbating the rate differentials between the dollar and other currencies. However, the Republican Party have traditionally been fiscal conservative so it remains to be seen whether the Congress will bless the spending without commensurate spending cuts in other areas so that the administration can fulfill its campaign promises to the American people.

The move will be gradual because otherwise it will create problems

The threat of a runaway dollar is a clear and present danger to the U.S. economy. As the dollar rallies, U.S. exports become less competitive on the global market as demand for U.S. goods will decline as they become more expensive. Therefore, I believe that we will see a gradual implementation of fiscal stimulus and a continuation of gradual rate hikes from the Federal Reserve.

At their December 2015 meeting, the Fed had indicated they would hike rates 3-4 times in 2016 but they only moved once. However, with the improvement in U.S. growth and the prospect for infrastructure rebuilding, it is likely that the Fed will live up to their recent guidance and short-term rates will move at least 75 basis points higher over the course of 2017.

Dollar strength appears to be a no-brainer in 2017. While the greenback index may pullback and test the technical support at 100.60 over the weeks ahead, the path of least resistance for the U.S. currency continues to be higher. With both technical and fundamental factors behind the dollar, the currency appears to be heading for the 109.75 resistance level and will continue to make higher lows and higher highs in the months ahead. Any sudden moves higher in the dollar could cause problems for equities and commodities but gradual appreciation of the currency will likely be the main focus of the new Treasury Secretary and the central bank. Managing the ascent of the dollar is likely to become one of the central focuses of the incoming administration.

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