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Uncertainty over global affairs and current Fed policy are expected to adversely impact growth in the U.S. dollar's value by the end of 2019. As such, we propose taking a long position in the ETF Invesco Currency Shares Euro Trust (FXE), which bets against the U.S.dollar relative to the euro. FXE is an ETF that tracks the price of the Euro. With an expense ratio of 0.40%, this ETF is a great choice as the USD will weaken relative to the euro.
For the first two months of 2019, one could infer that the U.S. economy is thriving after the stock market has achieved record growth, notably after an abysmal Q4 2018. In December 2018 alone, both the Dow Jones and the S&P 500 dropped 9%, the worst month since December 1931. Since the close of last year, the Dow Jones alone has given sight to a bull market with 11% growth. Between the Fed's decision to halt rate increases and uncertainty with U.S.-China trade negotiations, resulting in increasing trade deficits, the United States will likely see a depreciation of the greenback. A weaker dollar will occur as U.S. inflation increases and interest rates are stagnant.
U.S. Inflation Forecast:
Inflation in January 2019, as measured by the consumer price index for all urban consumers (CPI-U), was 1.6%, coming under expectations and lower than the prior month at 1.9%. According to the Federal Open Market Committee, the outlook for 2019 inflation, indicated by projected median personal consumption expenditures (CPE) is 1.9%, is anticipated to increase from its January level.
United States will see a growth in inflation under the fundamental principles of cost-push inflation. As the cost of production increases, aggregate supply of goods and services will decrease, causing the overall price level to increase. Higher inflation in the United States than the Eurozone will make American goods and services less competitive, and lower demand for the U.S. dollar, which in turn will result in a depreciation of the greenback.
Moreover, the expectation that inflation will grow in 2019 relates to implications stemming from uncertainty around the country's trade wars. As the demand for exports decreases, the U.S. dollar will depreciate. In 2018, new tariffs were imposed on $200 billion worth of trade imports which contributed to United States' trade deficit. By year end, the trade deficit escalated to record highs with 10% growth compared to the prior year, landing at $891.3 billion. U.S. exporters are paying the price as foreign countries are retaliating, by slowing down their consumption of American goods (e.g., soybeans, agricultural products) - primarily China, the United States' largest trade partner.
Furthermore, as a deal was not reached by the March 1 deadline, there is concern that China will begin expanding its trade relationships with Europe - which would spur economic output and strengthen the Euro. A trade surplus signals positivity and strength in the respective economies. If the U.S.-China trade deal fails, we predict a decline in the amount of trade surplus, which will undermine the two economic powers; therefore, putting downward pressure on the USD.
In addition to China's trade relations potentially shifting away from the US, in favor of Europe (major focus in Germany) or emerging markets, the production costs of goods and services in the U.S.will increase either from (i) the new tariffs imposed on imports and/or (ii) increased reliance on domestic goods and services that are more expensive. As previously referenced, an increase in the production costs limits supply relative to demand, driving up prices and making these goods and services more expensive. This has been seen before, notably when energy prices (e.g., oil) increase, and the cost is pushed down to the consumer with rising prices.
Although dependent on the outcome of U.S.-China trade war discussions, Brexit and the European Commission, the Organization for Economic Cooperation and Development is pointing to the "current downturn in European growth running out of steam and beginning to turn up in the next 4-5 months". Moreover, with the European Central Bank (ECB) working toward "normalization" of its interest rates as part of the aftermath of the Eurozone debt crisis, we predict this to give rise to the EUR. Both the announcement by the ECB on 3/7/19 that they will deploy a new stimulus program to help the economy, as well as February's U.S. weak job report (89% less jobs created than projected), are factors contributing to the future weakening of the dollar.
U.S. Inflation - Impact on USD/EUR Exchange Rate
In the chart below we have tracked the exchange rate between the USD and the Euro over the past twelve years. It is evident form the chart that historically there has been a negative correlation between United States inflation and the exchange rate. In rising inflation environments, the dollar has weakened relative to the Euro (e.g., 2007, 2011); whereas it has strengthened when consumer prices declined (e.g., 2008, 2014).
In 2014-2015, as the quantitative easing ended, and the Federal Reserve began monetary tightening, the dollar began to appreciate relative to the euro, especially since the European Central bank was conducting a looser monetary policy by announcing expanded asset purchase programs. The inflation in the Eurozone for the past five years has been trailing close to zero, compared to higher levels in the US, indicating a decrease in the purchasing power of the dollar compared to the euro. The correlation of -.31 between inflation and USD/EUR exchange rate for the past 12 years (monthly values) implies a weak connection between the two indicators. Further, based on the correlation coefficient, only 9% of the variance of the monthly exchange rate could be explained by the variance in inflation, implying the existence of other factors affecting the currency exchange rate, therefore analysis of the correlation between 10-year Treasury Yield and USD/EUR exchange rate is presented below.
Interest Rates and Inflation:
Earlier this year, the Federal Reserve made public statements indicating there would not be any interest rate hikes in the first quarter of 2019 despite former expectation to the contrary. The Fed has raised concerns that the economic slowdown and slow global growth in 2018 may not be entirely in the rearview, and although rates are not looking to go down in the near term, they are patient on recommending any increases.
As it relates to U.S. interest rates, the 10-year Treasury Yield declined from an average of 4.80% in 2006 to 4.63% in 2007, which was only further dramatized in 2008 when it fell to an average of 3.66% (21% decline). In support of the declining interest rate environment, the U.S. inflation rate continued to increase at this point as oil prices reached a high of $161 per barrel in June 2008. However, throughout the latter portion of 2008, oil prices dropped significantly to less than $50 per barrel (-69% change) which lowered production costs for goods and services allowing for price levels to come down (deflation). As such, the USD began losing value to the EUR reaching of 0.63 EUR to 1.00 USD.
However, the USD has appreciated against the EUR since 2015, as the United States has been going through an economic expansion phase until the fourth quarter of 2018, as the graph above illustrates. The higher yield in 10-year U.S. Government Bond Yields of 2.7% compared to 1.2% in 10-year sovereign bonds for the Eurozone, provided investor confidence in the dollar, which helped it rally to an exchange rate of 0.88 EUR to 1.00 USD in January. The USD/EUR exchange rate is negatively correlated to the 10-year U.S. Government bond yield, with a stronger dependency than inflation (correlation -0.53 based on monthly values for the past 12 years). Increases in the 10-year yields can explain around 28% of the depreciation of the dollar (correlation coefficient .28). As both inflation and interest rates in the United States are forecasted to slightly increase by the end of 2019, we will see a weaker greenback.
Since strengthening of the USD by the end of 2019 is unlikely, it is recommended that investors consider take a long position in the euro-centric FXE to obtain favorable returns. However, to hedge against risk associated with an unlikely, but potential strengthening of the U.S. dollar, it is recommended that investors concurrently take a short position in a U.S. dollar-centric fund, by purchasing a put option on Invesco DB U.S. Dollar Index Bullish Fund (UUP). UUP is an ETF with an expense ratio of 0.79%, that raises in value as U.S. dollar appreciates against a basket of currencies.
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