FM Wealth Management News Letter
Interest rates are rising yet the US dollar (UUP) is declining. As
demonstrated here by EURUSD., this has created some striking divergences
in rate differentials.
We can find several explanations for the weak dollar. We can chalk
most of it as a function of strength in other currencies.
The Euro has strengthened in anticipation of a Quantitative Easing taper, with CPI at 3% the Bank of England decided to raise rates, and the Yen recently has gone up on speculation of normalization brought on by slowing bond purchases. Domestically the dollar has been weakened by subdued inflation and the Trump Administration rhetoric.
However for the dollar to ignore rates during a Federal Reserve hiking cycle is harder to understand. So we need to drill down and take a look at similar historical precedents to understand what’s going on. The dollar declined in the mid to late 1980s and the mid 2000s under similar circumstances.
In fact it is important to note that the dollar’s 3.3% decline in January is the worst January performance since 1987 when twin deficits weighed. In other words, a key medium-term driver of dollar weakness, the current account deficit, is starting to kick in. In the fourth quarter, the US trade deficit widened sharply and leading indicators suggest the deficit will worsen over this year.
All this comes at a time when the US fiscal balance will likely worsen. We have seen the sum of the fiscal and current account balance (this twin deficits) has crossed the 6% of GDP threshold, which has coincided with major multi-year downtrends in the dollar. The prospect of further fiscal stimulus will therefore only make matters worse. SO as in the mid 80’s and 2000’s, welcome back to the world of twin deficits.
What Does This Mean?
Investors and markets have a habit of fixating on certain things and ignoring others. The focus changes when a tipping point is reached. The recent equity market sell off in response to higher interest rates is a good example – equities ignored rising rates since they reached bottom in September, but in recent weeks rates went too high, too fast, and this is dominating the headlines.
So therefore investors and the market are once more fixated on rates and at least temporarily, it seems the dollar is trying to find a bottom,
Though the Fed’s actions have not helped the dollar we suspect at weaker and weaker dollar levels, rates will gradually exert influence and help slow the pace of dollar depreciation.
Technical support also should help slow the slide The dollar is now trading at the 200-month moving average in confluence with the 2008-2010 breakout level.
So Where Does This Leave Us?
Many of you will be tempted to look for a contrarian trade and reversal in the dollar’s trend. We are seeing that the majority of analysts were bullish at the early 2017 highs, and are now almost universally bearish at the early 2018 lows. Goldman Sachs just lowered their targets to 86.8.
We think that the short players are outstaying their welcome. Our target from October was 88 based on a decline with similar proportions and drivers (with a longer timeframe).
We want to state that any reversal is purely speculative at this point in time, but even President Trump has recently stated, The dollar is going to get stronger and stronger and ultimately I want to see a strong dollar.”
This statement was mainly in response to Steve Mnuchin’s and Mario Draghi’s comments, but at some point Mr. Trump will want the decline to end, especially if the chart below has any significance.
Your Take Away
Last year rates have had little effect on the dollar as other concerns such as twin deficits have taken priority. Of course in recent weeks interest rates have come back sharply into focus, just as the dollar is testing technical support and data is coming in strong. Even though it may seem very unlikely we believe that a reversal of the downtrend is not out of the question.
The Euro has strengthened in anticipation of a Quantitative Easing taper, with CPI at 3% the Bank of England decided to raise rates, and the Yen recently has gone up on speculation of normalization brought on by slowing bond purchases. Domestically the dollar has been weakened by subdued inflation and the Trump Administration rhetoric.
However for the dollar to ignore rates during a Federal Reserve hiking cycle is harder to understand. So we need to drill down and take a look at similar historical precedents to understand what’s going on. The dollar declined in the mid to late 1980s and the mid 2000s under similar circumstances.
In fact it is important to note that the dollar’s 3.3% decline in January is the worst January performance since 1987 when twin deficits weighed. In other words, a key medium-term driver of dollar weakness, the current account deficit, is starting to kick in. In the fourth quarter, the US trade deficit widened sharply and leading indicators suggest the deficit will worsen over this year.
All this comes at a time when the US fiscal balance will likely worsen. We have seen the sum of the fiscal and current account balance (this twin deficits) has crossed the 6% of GDP threshold, which has coincided with major multi-year downtrends in the dollar. The prospect of further fiscal stimulus will therefore only make matters worse. SO as in the mid 80’s and 2000’s, welcome back to the world of twin deficits.
What Does This Mean?
Investors and markets have a habit of fixating on certain things and ignoring others. The focus changes when a tipping point is reached. The recent equity market sell off in response to higher interest rates is a good example – equities ignored rising rates since they reached bottom in September, but in recent weeks rates went too high, too fast, and this is dominating the headlines.
So therefore investors and the market are once more fixated on rates and at least temporarily, it seems the dollar is trying to find a bottom,
Though the Fed’s actions have not helped the dollar we suspect at weaker and weaker dollar levels, rates will gradually exert influence and help slow the pace of dollar depreciation.
Technical support also should help slow the slide The dollar is now trading at the 200-month moving average in confluence with the 2008-2010 breakout level.
So Where Does This Leave Us?
Many of you will be tempted to look for a contrarian trade and reversal in the dollar’s trend. We are seeing that the majority of analysts were bullish at the early 2017 highs, and are now almost universally bearish at the early 2018 lows. Goldman Sachs just lowered their targets to 86.8.
We think that the short players are outstaying their welcome. Our target from October was 88 based on a decline with similar proportions and drivers (with a longer timeframe).
We want to state that any reversal is purely speculative at this point in time, but even President Trump has recently stated, The dollar is going to get stronger and stronger and ultimately I want to see a strong dollar.”
This statement was mainly in response to Steve Mnuchin’s and Mario Draghi’s comments, but at some point Mr. Trump will want the decline to end, especially if the chart below has any significance.
Your Take Away
Last year rates have had little effect on the dollar as other concerns such as twin deficits have taken priority. Of course in recent weeks interest rates have come back sharply into focus, just as the dollar is testing technical support and data is coming in strong. Even though it may seem very unlikely we believe that a reversal of the downtrend is not out of the question.
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