Dollar View: Discipline or Stubbornness

new puzzleThe US dollar is sitting near multi-month lows against the major European currencies and the dollar bloc.   Where does this leave our strategic view of the third significant dollar rally since the collapse of Bretton Woods?

The dollar bear market ended in 2007-2008 when extremes were made, with the euro trading above $1.60 (2008), and sterling above $2.11 (2007).  The US dollar fell to nearly CAD0.90.  The yen is a notable exception. It did not put it a top until 2011.  That is also when the real broad trade weighted dollar bottomed as well.

We anticipated a secular dollar recovery.  My book, Making Sense of the Dollar (Bloomberg, 2009) argued against many of the “myths” that were used to justify and explain the dollar’s decade-long decline, like it was losing it reserve status, or that is chronic current account deficit was undermining its reserve status, or that the Chinese yuan was going to replace the greenback.

The first dollar rally after the demise of the Bretton Woods system was fueled by the tightening of monetary policy under Volcker and the expansionary fiscal policy associated with Reagan. After intervention (Plaza Agreement, 1985) had arrested the dollar’s rally, it entered the decade-long bear market.

The second dollar rally was associated with the tech bubble in the second half of the 1990s.  The groundwork was the Fed tightening in 1994 and the abandonment of the occasional practice of US Treasury Secretaries (like Baker and Bensten) of using the dollar as a weapon to force concessions from US allies.  In October 2000, at the behest of the ECB, there was coordinated intervention to stop the newly-born euro from falling further.  This meant capping the dollar.  It went through another multi-year bear market.

Early on, we identified the divergence of monetary policy, broadly understood, as the driver of the third dollar rally.   While the dollar bear market may have ended in 2007-2008, the bull market arguably did not begin until the middle of 2014, and the Fed’s first hike was not delivered until the end of 2015.

Our assessment that the third significant dollar bull market is still intact rests on both fundamental and technical judgments.  First, peak divergence is not yet at hand.  Specifically, we expect the Fed’s balance sheet to shrink by $30 bln in Q4, $60 bln in Q1 18 and $90 bln in Q2 18 for $180 bln reduction by the middle of next year.  During this time we expect the ECB’s balance sheet to expand by 300 bln euros (August through December) and by 180 bln euros in H1 18, for a total of another 480 bln euros.

By the middle of next year, we suspect the Federal Reserve will hike rates 2-3 times, while the ECB leaves its deposit rate at minus 40 bp   Interpolating from the OIS suggests the market is not convinced that the ECB will move on rates until Q4 18.

The second reason we are reluctant to abandon our bullish dollar outlook is the price action itself.  After a large move, it is not unusual to see a counter-trend move.  The question is how big of a counter-trend move before we say a new trend has begun.   People who study price action have come up with a few rules of thumb.  We use the Fibonacci relationships (especially, 38.2%, 50% and 61.8%) to measure retracements.  Other technical schools may use 25%, 33% 50%, 66% and 75%).

Although the dollar’s pullback this year is more than we expected, regarding retracements, it is still quite modest.  For example, using the euro peak of almost $1.40 in May 2014 and the low set at the start of this year near $1.0340, the single currency has almost met the 38.2% retracement at $1.1735.  The 50% retracement is found near $1.2170.   Sterling is nowhere close, but it has retraced 38.2% of the decline from the $1.50 high seen in June 2015 (which is found near $1.3055).  The 38.2% retracement of the slide from nearly $1.72 seen in July 2014 is almost $1.39.

The yen as often is the case, marches to a beat of the slightly different drummer.  The dollar recorded a low near JPY99 in June 2016.  It rallied to JPY118.65 by the middle of last December.  The greenback’s low for the year was set in April near JPY108, which is a little beyond a 50% retracement.  Last year’s low was just beyond the 50% retracement of the entire Abenomics-sparked yen depreciation.

The Dollar Index retraced 38.2% of its rally from the 2014 low at  94.30.  It made a low yesterday of 93.64 but finished the North American session back above 94.00.  It ran into offers today at it approached 94.30.  The 50% retracement is near 91.35.

We suspect the market sentiment has swung too far in Europe’s direction, having rebuffed the challenge by the populist-nationalists.  The eurozone continues to grow above trend, but the momentum appears to be stabilizing.     Macron’s election in France spurred several months of good feeling, but the honeymoon is over.  Macron’s program of labor market flexibility, spending cuts and tax cuts for the wealthy will spur a push back, which is what prevented Macron’s predecessors from succeeding with their reform agenda.  The top French general resigned over budget cuts, and Macron appears to have ruffled feathers by taking credit for developments in Libya that were initiated by Italy.

Similarly, we are concerned that investors may be too negative the US.   Market positioning, which had favored the dollar at the end of next year, now is heavily biased toward short dollar positions.  Neither the ISM, the Leading Economic Indicators, nor weekly jobless claims point to an imminent recession in the US.   It is true that political uncertainty and the unconventional US administration weighs on sentiment.  However, ultimately, we think monetary policy and the broader economy is more important.  It may simply require a greater interest rate premium to offset or compensate for this risk.

In conclusion, we identified the main economic driver of the dollar bull market as divergence, and we see it still being intact.  The dollar has depreciated, but it has barely met some minimum technical retracements that are common corrections in bull markets.  If these considerations change, we are prepared to reassess our outlook, but until they do, it seems premature to abandon our call.