“The reason that the US will continue to be the world’s decisive actor is the abiding centrality of the US dollar, a centrality that was established by the outcome of World War II and has remained continuously intact for 70 years to date.”
Commentary & Analysis
US Dollar Paths and Summary Rationales
A quick summary of intermediate- to long-term drivers of currencies:
As we know, growth and interest rates are inter-related and must be evaluated accordingly at different stages of the business cycle. But as the interest rate relates to currency values the best ongoing correlation is the direction of the yield spread, i.e. a higher yield spread tends to support a currency, and vice versa. Often the Japanese yen represents the exception to this rule because of the yen’s tendency to rally on risk given local money flow back into JGB’s.
So it’s the yield spread we watch (not interest rates themselves). In other words we watch how interest rates are doing relative to other currency competitors, i.e. relative yield. All things currency trading are relative.
The other key variable is capital flow, which again is an inter-related variable with both growth and yield; and can gain an added bump from policy changes in a country. And from a currency perspective, we try to judge capital flow in two different categories: 1) foreign direct investment, and 2) hot money flow. Both are important. But for the longer term, foreign direct investment is the structural stuff that stays, where as hot money sloshes around the globe seeking yield, then moving on.
And these flows into a currency can be self-reinforcing for all kinds of reasons—price appreciation begets more flow, capital flow increase collateral values leading to more flow, etc. Thus, a currency can become ensconced in either a virtuous or vicious circle; either everyone wants in, or everyone wants out. This is what leads to the “overshoot nature” we often see in currency values.
Policy as you know plays a key role in both expectations of growth and yield and whether a country represents fertile ground for foreign direct investment.
Up until recently, everyone was quite excited about the Trump Pro-business policy agenda. Most assumed the regulatory changes and tax reductions would drive the US dollar higher and higher. But the latest roadblock, or speedbump, depending on your perspective, seems to have changed the sentiment on the US dollar. A reality bite if you will for those who believed policy change was easy; it is not.
So here are three different scenario summaries for the future course of the dollar (granted, there are many others)…
1) Dollar has topped:
a) The Trump Agenda will fail or be significantly diluted given the unrelenting attack from left, establishment Republicans, the deep state, and self-inflicted wounds, with the upshot being much reduced real money flow in the form of foreign direct investment and repatriation; and
b) The global economy is still mired in grip of deflation and the overhang of massive global debt will continue to thwart global growth, especially if US growth is stymied because of policy disputes. This scenario would suggest Federal Reserve Bank interest rate expectations will be scaled back; which in turn would dent the US dollar yield spread over time.
Note: The divergence in the MACD at the bottom pane of the chart above. Often momentum is strongest in the third wave and we see divergence in price and momentum in the fifth wave, as shown above.
2) Healthy correction only:
a) It really should be no surprise the Trump Agenda is running into turbulence; real change isn’t easy and it requires sustained focused effort and coalition building. Despite failure on the health care bill (which may be a blessing in disguise as the Republicans can still hang the disaster of Obama Care on the necks of Democrats) there is little to suggest, yet, there won’t be progress on tax and regulatory reform--two drivers of real money flow as it relates to foreign direct investment into America. And there is plenty of time to circle back to health care.
b) The realization reform will take time may be coinciding with a belief its past time for other major central banks to consider reducing monetary accommodation; this sentiment change naturally will require a near-term re-rating for the dollar for now. But once the Trump Agenda gets back on track, later in the year, we could see dollar bulls re-emerge in a big way and drive the US dollar to new highs in wave 5 as labeled below:
3) Dollar risk bid on euro unraveling
The third scenario is one we are all familiar with. If the French elect Marine Le Pen, it could be lights out for the single currency regime, as Ms. Le Pen has vowed to hold a referendum on EU membership—a Frexit, if you will. The prospect of this and ongoing concern surrounding Brexit resolution with the EU, and geo-political turmoil in the real world, may just be dollar supportive and we could see some meandering price action till late April. And if Ms. Le Pen surprises the world, as Brexit did, the US dollar is likely to soar. There will be no deep correction, just a rocket launch into new high territory which will be very bad for emerging markets and could trigger some real turmoil in multiple regions of the globe at the same time.
All these scenarios have a degree of plausibility. If push comes to shove, I think the first scenario makes most sense—a healthy dollar correction then another leg higher. But the other element pushing against this scenario is the fact the US dollar has been in a bull market for nine-years, it is getting long in the tooth. So, confidence about another leg higher is moderate at best.
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