Introduction: The 2018 Story
Last year, there were a variety of factors pricing in further USD depreciation following the 10-percent fall in 2017 (using the USD index), its worst year since 2003. Following the large fiscal stimuli announced by the Trump administration, the macro "story" was that twin deficits in the US were naturally going to weigh on the dollar in the medium term. Figure 1 (left frame) shows that with the exception of the early 1980s, the US dollar tends to co-move strongly with current account and fiscal deficits over time. In addition, running a loose fiscal policy in a tight labor market with an unemployment rate at its lowest rate in almost 50 years raised the following question: what happens if the US economy faces another downturn? Figure 1 (right frame) shows an interesting divergence in recent years between the fiscal deficit and unemployment rate; with deficits expected to exceed USD 1 trillion every single year in the next decade, the US is currently running post-crisis stimuli when the unemployment rate was much higher.
We know that over time, in a weaker USD scenario, US equities tend to underperform world (ex-US) equities as better opportunities emerge in the EM space. Figure 2 (left frame) shows the YoY change in the USD real effective exchange rate (REER) with the relative performance of US vs. world equities. We can notice that the annual performance of the US dollar tends to mean revert over time, oscillating between -10% and +10%. Hence, higher world equities relative to the US in addition to an outperformance of undervalued currencies such as the euro or the Japanese yen were the main 2018 trades supporting the USD weakness coming ahead. Figure 2 (right frame) shows the extreme divergence between the EURUSD exchange rate and its PPP "fair" value estimated at 1.38 according to Eurostat-OECD.
USD Non-Reaction To The Fed's Pivot
However, the non-reaction of the US dollar to a series of macro events surprised many market participants, which leaves us skeptical about the outlook of the currency. First of all, the significant deterioration in economic data since the beginning of 2018 has not impacted the greenback at all; the Citi economic surprises index decreased from 80 in early January 2018 to -69 in April 2019 (figure 3, left frame). More importantly, the Fed's pivot in reaction to the equity sell-off we saw in the last quarter of 2018 did not create any shock on the dollar. Fed Chair Powell's comments on the Fed Funds rates switched from "long way from neutral" in early October to "appropriate stance" in the late January conference. We saw a significant reversal in the Eurodollar futures market, with participants now pricing a cut for this year and a 40bps implied rate cut for 2020 (figure 3, right frame).
Short-Term Drivers: IR Differential, Real Growth Differentials, Uncertainty
With a Fed Funds rate at 2.25/2.5%, the US currently has the highest policy rate among the G10 economies. Therefore, the interest-rate differentials remain one of the major driving forces of the US dollar in the short run, especially against the euro. Even a commodity country such as Australia, which in history had had a higher policy rate than the US, has a cash target rate at 1.5% (figure 4, left frame). The second fundamental driver in the short run is the real growth differential between the US and the major economies. We saw recently that Australia was facing a slowdown in the housing market and that the collapse of excess liquidity in China (figure 4, right frame) was going to weigh on the property market of the commodity countries (Australia, New Zealand and Canada) in the months to come. In addition, leading economic indicators of core countries in the Euro area such as France in addition to the political situation in Italy were both going to impact the euro, hence pushing up preference for the US dollar in the short run.
USD (UUP) View
The US dollar broke an important support against the euro at 1.1185, which corresponds to the 61.8% Fibo retracement of the 1.0340-1.2550 range, and seems on its way to retest its first psychological support at 1.11. We missed our entry point on the pair (see FX weekly); however, we mentioned several times that the single currency remains vulnerable in the current economic environment.
Figure 5 shows that the USD index broke a key resistance at 97.92, which corresponds to the 61.8% Fibo retracement of the 88.2-103.92 range. The next resistance level stands at 100.20 (76.4% Fibo), which was also the 2015 resistance. Momentum looks clearly bullish, hence confirming more upside room for the US dollar in the next two to three months to come.
Disclosure: I am/we are short USDJPY. 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.