What Is The U.S. Dollar Saying About The Economy?

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by: John M. Mason
Summary

The US dollar has rebounded in foreign-exchange markets since late March and continues to remain strong as the US economy remains relatively strong.

The US dollar will remain strong as long as the US economy remains relatively strong and this is where the concerns need to be expressed.

Most economists seem to believe that the current strength of the economy will not be maintained because its strength is coming primarily from short-run fiscal stimulus that will not last.

Thursday morning, June 21, 2018, the value of the US dollar rose to a level not seen since the middle of July 2017. The US dollar index (DXY) hit 95.50 in early morning trading and this is the strongest the currency has been since its near-term trough of 89.00 in late March of this year.

There seem to be two reasons for this strength. First, the United States economy is growing faster than many of the other major economies in the world. Second, the central bank of the United States, the Federal Reserve System, is expected to raise its policy rate of interest faster than other central banks in the world, thereby increasing spreads between US rates and those of other countries.

This is why the value of the US dollar has been increasing since March and will continue to serve as the foundation for further increases in 2018.

In terms of economic growth, economists have been raising projections for the second quarter of 2018 and for the full year.

For example, the Federal Reserve has recently raised its projections for 2018. Currently, the Fed has increased its forecast for 2018 to 2.8 percent, up from 2.7 percent a couple of months ago, and up from 2.4 percent not that long ago.

Some private sector economists have raised their projections to 3.0 percent for the year.

For the current quarter, estimates are coming in as high as an annualized rate of 4.5 percent or above.

This would be the fastest quarterly rate of increase in real GDP for the current economic recovery.

It should be noted that at the end of this quarter, the current recovery from the Great Recession, which ended in the second quarter of 2009, will be nine years old, one of the longest recoveries on record.

But, it has also been one of the slowest recoveries on record showing only a 2.2 percent annual compound rate of growth during the period of recovery.

The economic projections for 2018 are counting on an additional thrust to the economy coming from the tax reform package passed in December 2017 and the two-year budget deal reached by the US Congress in February of this year.

Added strength is expected to come from the Trump administration’s efforts to reduce regulation and governmental oversight. And, at least initially, the Federal Reserve’s actions, raising its policy rate of interest and reducing the size of its securities portfolio, are not expected to produce a major constraint on the economy as bank lending and money stock growth are expected to run in the 4.0 percent to 6.0 percent range.

The reasoning behind this is that the Fed’s interest rate moves come as the stronger economy supports higher interest rates and that the reduction in the Fed’s securities portfolio will not substantially reduce the overall liquidity in the banking system due to the historically large amount of excess reserves that exist within the commercial banking system.

All of this contributes to the reason for the relatively strong performance of the US dollar against other currencies.

The question becomes, how long will these conditions exist?

Looking back at the projections provided by the Federal Reserve, the answer to this question is…not too long.

Returning to the 2018 projections of the Fed cited above, the officials at the central bank think that the rate of growth of the economy will drop off to 2.4 percent in 2019, to 2.0 percent in 2020, and to 1.8 percent in the longer run.

So, the expectation is that the fiscal policy stimulus noted above will only be of very short-run impact, primarily centered in 2018.

In the second link provided above, the claim is made that “the good news may not last,” and the growth achieved in the second quarter of 2018 “likely will be the peak growth for this cycle.”

There are two reasons for this. First, the fiscal stimulus provided by the Trump administration will only produce a short-term impact. Second, in order to maintain control over the economy’s rate of inflation, Fed officials will turn from increasing its policy rate in conjunction with the strong economy to actually trying to slow down any further increase in economic growth so as to constrain inflation.

If economic growth slows down, like Fed officials seem to expect, the current strength of the US dollar could be diminished.

An added uncertainty, however, that some economists are talking about, is further movements on the tariffs front. Although some of these economists are saying that the strong US economy versus the relatively weaker economies elsewhere in the world will give President Trump some bargaining power that will benefit the United States. However, many contend that a general rise in tariffs will not be helpful in sustaining further economic growth.

This would probably not be to the benefit of the US dollar.

So, for the short run, I am expecting the US dollar to stay strong in the foreign-exchange markets. However, over the intermediate- to longer-term horizon, the value of the dollar will probably back off a little and then remain at that level for a while.

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.