Why Central Banks Will Send The Dollar Lower In The Coming Months

Summary

• Interest rate differentials are bullish for the dollar, but it is going lower.
• The ECB is about to copy the Fed, again.
• The ascent of the dollar started with news of tapering.
• A similar move in the euro would take the dollar index through critical technical support.
• Commodities should be the biggest beneficiaries of a lower dollar, maybe.

The global financial crisis of 2008 turned the central banks of the world from bankers to firefighters. The alarm bells rang in the halls of the world’s central banks and monetary authorities as the housing and mortgage-backed securities crisis in the United States and the sovereign debt crisis in Europe increased the prospects of global recession or even depression. The U.S. Fed led by Chairman Bernanke, a student of the Great Depression in the 1930s, dug deep into his monetary toolbox as the Fed slashed interest rates and introduced a program of quantitative easing, or repurchasing debt and putting in on the balance sheet of the central bank. These tools served to stimulate the economy by inhibiting saving and encouraging borrowing and spending. QE and low rates added mountains of liquidity to global financial markets, and the European Central Bank followed the U.S.

In 2014, as U.S. economic data was showing signs of stability and moderate growth the Fed announced it would taper its QE program and provided guidance that the end of a zero interest rate environment was nearing. The prospect of higher short-term rates caused the dollar to take off to the upside as the dollar index rallied by over 27% from May 2014 to March 2015. Since then, the Fed has been increasing the Fed Funds rate gradually, and it now stands at 1.25%. At their most recent June meeting, Chairperson Janet Yellen told markets that rates would likely rise by 25 basis points more by the end of 2017, and there will be as many as three more 25 point increases in the Fed Funds rate in 2018. Moreover, the Fed will begin to unwind the legacy of QE, allowing $50 billion to roll off their balance sheet each month. The rate hikes and plans to trim the balance sheet reflect the most hawkish monetary policy by the Fed in more than a decade. While rates continue to be in negative territory in Europe and Japan and the ECB is still operating their QE program, one would think that the dollar would be roaring higher. After all, interest rate differentials typically drive foreign exchange rates. However, the dollar has been dropping since January, and it is currently sitting at the lowest level since October 2016.

Interest rate differentials are bullish for the dollar, but it is going lower

The current short-term yield on the U.S. dollar is around 125 basis points as the Fed has increased the Fed Funds rate from zero to that level since December 2015. At their July meeting, the central bank told markets that they intend to hike the rate one more time in 2017 and anticipate three more twenty-five basis point increases in 2018.

In Europe and Japan, short-term rates remain at negative forty basis points, and quantitative easing in Europe has the ECB purchasing sovereign and some private sector debt. The QE program will run until at least the end of this year. Therefore, interest rate differentials between the U.S. currency and euro and yen currencies are currently at 165 basis points and are likely to rise to 190 points by the end of 2017.

Perhaps the most significant determinate of the value of a currency in the foreign exchange market when it comes to the major currencies of the world is interest rate differentials. The current level of U.S., European, and Japanese short-term rates should be bullish for the dollar, but it has moved lower since the beginning of 2017. Source: CQG

As the weekly chart of the U.S. dollar index highlights, the dollar rallied to the highest level since 2002 following the U.S. Presidential election in November 2016, reaching a high of 103.815 at the very beginning of January. However, since then, and after two interest rate hikes by the U.S. Federal Reserve, the dollar index has declined to lows of 95.225 at the end of June and was trading at 95.422 on Tuesday, July 11. While interest rate differentials should support the dollar, the greenback has moved over 8% lower against a basket of other currencies including the euro and yen over the past six months.

The ECB is about to copy the Fed, Again

Understanding the plight of the dollar these days could be as simple as looking back three years and a few months in history. The dollar index was trading at 78.93 in May 2014, and when the central bank indicated that quantitative easing could come to an end and there would eventually be a shift in monetary policy from accommodation to tightening, the dollar blasted off to the upside rallying to the 100 level just ten months late in March 2015.

Recent comments from ECB President Mario Draghi have become more hawkish, and it appears that European QE will come to an end sooner rather than later and rates will begin to rise from negative forty basis points. It was the guidance above a reversal of monetary policy in the U.S. back in 2014 that caused the over 27% rally in the dollar, and now it could be a change in posture by the ECB that will have a similar effect on the euro currency.

The ECB followed the Fed into years of low rates and quantitative easing in the aftermath of the global financial crisis in 2008. Now, the ECB could be following the Fed once again as they shift towards a tighter orientation to credit. Source: CQG

As the daily chart of the September euro currency futures contract shows, the European currency has rallied from lows of $1.05 on January 3 to its current level at over $1.15 on July 11. The recent moves in the euro have come after hawkish statements from the ECB.

The ascent of the dollar started with the news of tapering

In 2014, the dollar began to rally as the Fed announced their intention to taper quantitative easing. It is interesting that even the U.S. central bank’s recent statement that they will commence rolling the legacy of QE off their balance sheet at a rate of $50 billion per month has done nothing to support the dollar. It was the announcement in 2014 that got the dollar going, and we could be on the verge of a similar announcement from the European Central Bank.

A similar move in the euro would take the dollar index through critical technical support

The rise of over 9.5% in the value of the euro when compared to the U.S. dollar in 2017 has found support from recent ECB comments over the past few months. If the euro were to follow the path of the dollar over coming months, a 27% rally would take the currency to over $1.33 against the greenback. A rise of that magnitude would be shocking for the currency markets. However, the euro does not have to move that far to cause the dollar to fall below the critical level of technical support on the monthly chart. Source: CQG

As the monthly chart of the dollar index illustrates, the trend remains lower, and the line in the sand for the bull market in the greenback that dates back to May 2014 is currently at 91.88 on the index. The 10-point move in the euro since early January translated into an 8.5 point move in the dollar index. At 95.422, the index is 3.542 points above support. A further increase in the euro versus dollar relationship to the $1.20 level over coming months could cause a technical breakdown in the dollar index below support at 91.88. At the same time, while past U.S. administrations had pursued a “strong dollar policy,” the Trump Administration has stated on many occasions that they would prefer to see the dollar move lower to stimulate trade and make U.S. exports more attractive on global markets.

It looks like the only thing the dollar has going for it these days is the interest rate differential between the euro and yen, but that appears not enough to boost the greenback which looks ready to steam towards its critical support level sooner rather than later.

Commodities should be the biggest beneficiaries of a lower dollar, maybe

Despite the weakness in the dollar over recent months and potential for further losses when compared to other world currencies, the dollar remains the reserve currency of the world as central banks hold dollars more than most other currencies as reserve assets. The dollar has long been the pricing mechanism for raw material prices because of its stability and the fact that the U.S. remains the richest nation on earth. Therefore, there is a historical inverse relationship between the dollar and commodities prices. The bearish posture of the dollar should be supportive of the prices of many commodities over coming months if the historical trend holds. However, commodities are facing another influence these days aside from the changing foreign exchange rate of the dollar.

Global interest rates have fallen to levels that were artificially manipulated by central banks around the world to foster spending and borrowing and inhibit savings following the financial crisis of 2008. Low rates of interest were supportive for raw materials as they caused the cost of carrying inventories to decline. With U.S. rates rising and the potential of the same in Europe over coming years, higher interest rates could weigh on the prices of many commodities offsetting the bullish influence of a falling dollar. Of course, the economic conditions that are changing central bank policies from accommodation to tightening are the result of moderate growth, increases in the employment markets and a slight uptick in inflationary pressures. However, we will have to wait and see if commodities decide to follow the dollar or interest rates that are currently pulling raw material prices in opposite directions.

I believe that central bank policy in Europe, now that it is certain the Union will continue after the election in France and a probable victory of Chancellor Merkel in Germany in September, will move quickly from accommodation to a more hawkish stance. Higher European rates will likely cause the dollar to fall further, and when it comes to commodities prices, we could see a bifurcation within raw material sectors over coming months. Commodities prices are not likely to move as an asset class, rather individual raw material markets will march to the beat of their supply and demand fundamentals.

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Analyst’s 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.