Outside of several short-lived efforts to scratch out an upside move, one in the closing days of March through early April and a much less inspired attempt in the second week of May, the dollar has finally settled on a broadly downward trajectory since the latter part of the first week in March. While the dollar slides, overall economic fundamentals remain steady but mixed. The April jobs report posted well above population growth as the unemployment rate dropped to 4.4%, its lowest post since May of 2007. Wage growth on the other hand, remained decidedly weak at 2.5%, especially given the rise in headline inflation which hit 2.2% during the month on a year-over-year (YOY) basis. Industrial production jumped 1% during the month on the heels of March's surge in automobile production that has more recently turned into a supply overhang prompting a string of announced adjustments at both Ford (NYSE:F) and GM (NYSE:GM)-including firing Ford's CEO Mark Fields-as overall demand for cars and profits at Ford weakened in the all-important US market.
Meanwhile, the political climate in Washington has turned dour as the Republican Congressional leadership struggles to keep its ambitious agenda of tax cuts, health care reform and infrastructural spending on track amidst a steady drumbeat of explosive revelations and other legally ensnaring distractions emanating from the other end of Pennsylvania Avenue. Last week, the appointment of an independent counsel has cast a dark cloud over the White House which struggles to keep on message. The dollar, after a topsy-turvy roller coaster ride for the past several months has settled on what appears to be a steadier albeit downward path largely in the wake of the Justice Department's announcement as investor support simply collapsed (see Figure 1, below).
Figure 1: US Dollar Index
Across the pond, the euro has taken a rather different path posting an eight-month high against the dollar. While the European Central Bank (ECB) continues its €60 billion/month asset purchase program across much of the euro-zone, headline inflation hit 1.9% in April YOY, up from 1.5% YOY in March. Core inflation, ever the recalcitrant data point, hit 1.2% in April YOY-its highest post since 2013. Service prices were up even more at 1.8% for the month, also a four-year high. Energy and food prices (up 7.5% and 2.2% respectively) provided the main inflationary drive for the period. With the decisive defeat of far-right Marine Le Pen in April's second round of voting, France's position as a fulcrum of the European project remains intact. Investor support of the euro is vividly on display. Whether early calls by President, Emmanuel Macron for the easing of Brussels' fiscal rules, greater fiscal monetary integration-including the launch of Eurobonds fall on attentive or the tin Berliner ears of old-remains to be seen. Of course, the German national elections are slated for September. After a March win in local elections by Angela Merkel's Christian Democratic Union (CDU) in the Saarland and another last month in North Rhine-Westphalia, the political momentum has shifted unexpectedly to the CDU in the national contest in September. In the meantime, the euro continues to enjoy a good deal of support as the dollar continues to struggle (see Figure 2, below).
Figure 2: The Euro Index
Even the lowly British pound has enjoyed a good deal of investor support of late after a choppy first three months of the year. Betting against the pound has been the flavor of the day, week, month and much of the year since the Brexit referendum vote in June 2016. The short-term position of the British economy has turned to the upside this side of the snap June elections that, according to polls, could hand Mrs. May upwards of 100 seats in the House of Commons-a major increase on the party's 17-seat majority position today. Polls have Labor's share of the electorate at levels never before seen by a national party heading into a general election-with years in the political wilderness to look forward to in the aftermath. The polls have narrowed somewhat with the most recent projection having Labor down by 10%, down from about 20% earlier in the campaign. The economy continues to respond beyond most expectations with the IMF recently adjusting its growth projections for GDP growth to 2% for the year. All of this despite worries about UK productivity which fell 0.5% through the end of the 1st quarter in the face of real wages dropping for the first time in three years. Headline inflation soared 2.6% during the month of April YOY which makes high household debt and servicing that debt all the more difficult. Rising inflation also applies upward priced pressure on home prices and rents, further squeezing household budgets. The main driving forces of inflation, particularly energy and food, are largely denominated in foreign currencies. At the same time, the pound crossed the $1.30 threshold last week (19 May) on the surmise that the Bank of England (BOE) will be forced to raise interest rates to stifle inflation that is badly outpacing the rate of wage growth in the greater economy. Investor support for the currency is being pressured on the downside to more sustainable levels. That has not stopped UK importers from scrambling to renegotiate supply term hedges to lock in fixed contract prices as close to current market highs as possible. Borrowing costs in the UK continue to hover about historic lows. Last week the Debt Management Office sold gilts that are scheduled to mature in the mid-21st century with a yield of 1.7%. Investors submitted bids to sell the deal six times over-this at a time when the country is in the midst of a national campaign and facing down the complexities of Brexit discussions with unknown ramifications for both negotiating parties that begin next month. The hint of an increase in UK credit risk does not appear to be in the air. That said, foreigners still hold 30% of the UK national debt (see Figure 3, below).
Figure 3: The British Pound Index
The Bank of Japan (BOJ) buys about ¥1.2 billion of ETFs in any single trading day either from the Nikkei or Topax exchanges, with buying bursts in the range of ¥70 billion once or twice every week, according to traders. Since April 2016, the BOJ has increased its ETF buying cap to ¥6 trillion. Making money in the Japanese markets has shifted decidedly away from stock analyses, trading trends, company earnings or any of the other more traditional tools to trading on the heels of the BOJ. The yen is just coming off of a multi-week profit-taking slide spanning the latter part of April and into early May with support currently building. The Japanese economy has been on a tear as of late, particularly in comparison with where the economy has been over the past two decades. Annualized GDP growth clocked in at 2.2% through the end of the 1st quarter for the fifth consecutive 3-month period of growth-the longest growth spurt in over a decade. Growth in the 1st quarter was mainly driven by exports as a weak yen provided a comparative advantage for its goods in world markets. On the domestic, consumer spending and corporate investment remained weak as companies remain wary of raising prices lest the weak demand on display for goods and services weakens even further. The inability to raise domestic prices continues to wreak havoc on the economy's and the BOJ's ability to generate price inflation. As a result, nominal annualized prices actually fell 0.1% while headline inflation rose by a scant 0.2% YOY during the month of April (see Figure 4, below).
Figure 4: The Yen Index
The dollar has been whipsawed by markets for much of the year as the uncertainties around the ability of the Trump Administration to push its fiscal, health care reforms and infrastructural spending priorities through Congress heighten. The recent stream of scandal-evoking revelations currently being investigated by House and Senate committees and now by an independent counsel adds a whole new dimension to the equation that threatens to undermine the Trump presidency itself. The confluence of these factfinding endeavors, including the parade of witnesses scheduled either voluntarily or compelled via subpoena will add further downward pressure on the dollar for the foreseeable future. As the investigation continues, the cloud over the presidency will invariably darken as new revelations come to light. A slow and methodical undermining of the Trump presidency moving forward is close to a foregone conclusion. The probability of an early termination of the Trump presidency at this stage in the process is likely low-but certainly not zero. The impact of the unknown unknowns of the investigations is impossible to call at this juncture. The yield on the 10-year Treasury note has fallen just over 7% on the year with yesterday's close of 2.236%, but has increased 2.20% since last Wednesday's market swoon (17 May) that erased 1.8% in market value from the S&P 500. The VIX has also pulled back from its 46% spike on the 17th of May, settling at a reading of 10.93 at yesterday's market close (22 May). That said, the VIX straddles a powder keg that could easily be set off with the next revelation-from either end of Pennsylvania Avenue. A long position like Powershares Ultra VIX (NYSEARCA:UVXY) would capture such upward thrusts of the VIX as investors scurry for insurance protection against equity losses. The reverse trade would be a short position such as Velocity Shares Inverse VIX (NASDAQ:XIV) which makes money as VIX positions unwind in the aftermath. Making both plays in qualified accounts eliminates short-term tax consequences.
A more positive spin on the dollar comes courtesy of the Federal Reserve with the release of the minutes from the May meeting of the Federal Reserve, due tomorrow (24 May). The likelihood of the Fed raising short-term interest rates at its June open market committee meeting is currently running at an 81% probability, according to federal funds futures contracts through today's market close (23 May). Higher short-term interest rates historically support the dollar in world currency markets.
Turning to the British pound, the Brexit negotiations will remain an unknown well into the negotiating process. If the Brexit talks get bogged down over past, present and future UK liabilities from the opening gun without a quick agreement by the two parties on some payment schedule pushed off decades into the future, the pound will likely take the impasse badly. If prices in the greater economy continue to rise, consumer purchasing power will continue to erode. Retail spending was unexpectedly weak through the end of the 1st quarter as household spending fell off as did manufacturing which has been benefiting from comparative advantages in world currency markets due to the weakened pound since the Brexit vote in June of last year. Consumer borrowing increased at double digit annual rates last year-debt levels that will be difficult to service with rising inflation. Real wage growth will likely continue to be outpaced by the accelerated pace of inflation in the greater economy-short of BOE intervention. A typical wage packet of a British workers is now projected to be no more in 2021 than it was in 2008 due to the precipitous rise of price inflation fueled mainly by a weakened pound. Brexit supporters used the erosion of pay packets to bolster the case for placing strict limits on labor pools coming into the country from Eastern European countries, advancing the dubious argument that ending the availability of such labor pools in the country, employers will be forced to raise wages. There is little historical evidence supporting such a thesis.
The government's inability to manage Brexit expectations has been nothing short of biblical. From the implausibility of reaching a UK-EU trade agreement by 2019 to the government's insistence on frictionless access to the single market to rejecting the four freedoms and the jurisdiction of the European Court of Justice-expectations continue to remain dangerously unglued. Ireland, Scotland and Gibraltar remain potent issues that will defy quick fixes. Britain's negotiating hand remains incredibly weak by most measures as the negotiations start in earnest next month. The two-year timeframe (actually 18 months) is woefully inadequate to negotiate the divorce agreement, let alone a full-fledged trade agreement. The snap national elections called for June pushes the next electoral cycle to June 2022, allowing more time more time for a transitional trade agreement to take shape. But the lack of expectation management coming into the Brexit process makes dealing with unexpected turns in the negotiations all the more problematic. The pound, the cost of borrowing and price inflation in the greater economy-will sketch out that hard realism and the resulting picture could get ugly.
Disclosure: I am/we are long UVXY.
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.