It is time to refocus on the US Dollar, as a trough may be close
This is a follow-through to our earlier article on the US Dollar ("It is time to refocus on the US Dollar as a key driver of risk-on, risk-off, CIW, April 12, 2016). In that article, we made the following observations and forecasts:
"Following the recent Fed comments, market participants remain convinced that the US Dollar will have further to go to the downside. The Fed is thought to be dovish; and the market is even more so. Based on this negative currency sentiment, we deduce the following eventualities:
(1) the US Dollar (DXY) will probably fall to the area of at least 92.00 perhaps lower;
(2) the crude oil price is more likely to go to $45 than to $30 in the short-term;
(3) gold prices will likely test $1300 again;
(4) base metals could follow through with one more leg up, continuing the uptrend phase which started in February."
"The key factor to all of these (observations) is that the market believes the Fed is unlikely to raise rates, even at the tepid pace that they announced after the March FOMC meeting during which they surprised the entire world by not tightening policy. In the press conference after the meeting, Fed Chair Yellen cited slow global growth, specifically in China and other emerging markets, as concerns."
The US Dollar DXY did fall to as low as 92.55 yesterday, and it looks like the unit will make a robust test of 92.00 later in the week. And as we said before, it may be time to refocus on the US Dollar, because if it will strengthen again, as we expect it would, then many of the market assumptions about the benevolence and longetivity of the current risk asset price rally may be put to test. A new USD rally would have unambiguous, negative impact on hard assets. The initial enthusiastic surge in commodity prices and in the assets in the EM space since February, which has continued early this week, would likely be "retraced" and some of the gains would be given up.
Investors should not rejoice too much about the US Dollar being weak. For instance, there has been a dark side to the dollar selloff. The dollar has weakened partly because inflation expectations in Japan and, to a lesser extent the euro area, have declined. The effect of these developments was to push up real yields in these countries, thereby putting upward pressure on the euro and the yen. Japan could not afford to be saddled with a strong currency at this juncture. Neither the Bank of Japan nor the European Central Bank had been happy with rise in their currencies (which have a weak USD as consequence). The preferable outcome should have been for both currencies to have rallied because a stronger economic outlook in those economies would have given investors hope that the ECB and BoJ could raise rates not too far from now.
The Federal Reserve also had a role to play in the recent USD weakness -- a suprisingly more dovish Fed exacerbated the downtrend of the US currency. However, there is a risk that the soothing words from Chairman Janet Yellen in recent weeks could give way to more hawkish rhetoric as the Fed begins to prepare the market for two (or more) additional rate hikes in the second half of the year (see our main CIW story this week).
Aside from the change in Fed rhetoric, other economic variables that are within the Fed's twin remit may act to change market perception as well. Recent US inflation data has surprised on the upside, with core CPI rising at a 3% annualized pace over the past three months. Wage gains have remained muted, its true, but just because wages tend to react with a lag to labor market developments. Official statistics may also be not measuring wage growth accurately. The inflow of low-skilled workers back into the job market has artificially depressed average hourly wages.
Nonetheless, the Atlanta Fed's Wage Growth Tracker shows that "true" wage growth is now over 3%, double what it was in 2010 (see chart below). These data are consistent with others which suggest that the labor market is tightening. The unemployment rate has fallen to 4.9%, just a smidgen off the Fed's 4.8% estimate of the rate of full employment.
All these factors are supportive of our forecast that the US Dollar should be on the way up over the next few months. It could cause a pullback in the price of risk assets. Nonetheless, we see a forthcoming "correction" as a "healthy" development from a price discovery point of view. The next uptake in risk asset prices should make back the ground that will be yielded in any short-term correction-- and gain even more thereafter.
Investors are not prepared for a more hawkish Fed, as evidenced by the continued wide gap between market expectations and the Fed's SEP "dots". Even a modest increase in rate expectations could send the dollar soaring, given the likelihood that other central banks will eschew rate hikes for many years to come. The implication is that any tightening in financial conditions that the Fed may want to engineer may primarily be achieved through a stronger dollar, rather than higher Treasury yields. Tinkering with the interest rate structure has may unintended effects and repercussions -- massaging the US currency via influencing market expectations is easier and probably even more effective.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.