US Dollar – Is This Rally Invulnerable…Hardly
Fundamental Forecast for US Dollar: Neutral
The US dollar extended its incredible performance this past week. The greenback advanced against most of its most liquid counterparts this through the period – with the exception of AUDUSD which failed a 1.0150 breakdown – speaking to an underlying strength. As for performance, the Dow Jones FXCM Dollar Index (ticker = USDollar) advanced for an eighth consecutive week. That is the longest consecutive series of gains for the index since historical price action was available back in 1999. The market benchmark is showing exceptional strength. The only drawback in taking advantage of this incredible drive…it contradicts most fundamental themes.
Though the dollar represents many things – the US economy, the largest capital market, a prolific range of stimulus – the FX market will always inevitably circle back to the benchmark’s primary role: the market’s preferred safe haven. That is where we start to see some unusual behavior from the currency. Given its fundamental position, we would expect the greenback to move in the opposite direction as a standard-bearer for the risk appetite. And yet, we find the USDollar at a two-and-a-half year high at the same time that the Dow Jones Industrial Average has moved to a record high. Furthermore, the foreword-looking fear gauge in the VIX volatility index has retreated to levels just off of five-year lows. Both relationships are highly unusual.
So what does this mean? An argument that I have heard more brought up frequently as of late is that the dollar is making the transition to an ‘investment currency’. That would suggest that the currency is attractive to those seeking higher rates of return. There are a number of issues with this theory. First and foremost the benchmark yield in the US is at a record low and the Federal Reserve has stated its intention to hold it there for through the foreseeable future (technically until medium-term forecasts call for a 6.5 percent unemployment rate and/or 2.5 percent inflation level). Market rates – at a premium over the Fed rate – are equally anemic.
Furthermore, we don’t even have the proper elements for a sustainable risk appetite trend in the currency market. An ‘investment’ (versus speculative) trade in the FX world typically follows the lines of carry trade. Not only does the US benchmark not provide meaningful yield, the entire market is suffering anemic rates of return – the aggregate 10-year government bond yield index I follow is slightly off its recent, historical low set last year. If a trader were seeking a greater rate of return, the Australian and New Zealand benchmark bond yields offer premiums of 150 and 170 bps respectively. Even those are at respective, historical lows…
Truly, the piece that does not fit is the assumption of risk appetite itself. While the benchmark US equity indexes climb and volatility measures shrink, we don’t see the other elements of a strong investment environment (rising rates of return, economic growth, reinvestment, employment, etc). What we are seeing is central bank stimulus remove perceived risk in the market and providing an opportunity for investors to frontrun their heavy-handed buying. The Fed and other central banks can only participate for so long, and in the meantime, we are already seeing traditional volume recede to worrisome levels.
Given the lack of participation and the knowledge that the safety net will eventually be withdrawn, these markets grow increasingly at risk of profit taking / deleveraging. Under that scenario, would the dollar drop back like equities? If the move is a market-wide risk aversion move backed by momentum (if there were a visible vein of panic in other words), the flight to safety would benefit the dollar in most scenarios – with the exception of USDJPY. In the meantime, the stimulus war will substitute the dollar’s risk ties. Currently, the Fed is the most prolific stimulus runner in the world – by a wide margin. Yet, the $85-billion-per-month effort is largely priced in through the end of the year. Meanwhile, the time frame for the BoJ’s 13 trillion yen ($135 billion) per month program has moved forward and the BoE is expected to join the fray soon. It’s a complicated world, but the EURUSD and AUDUSD offer more grounded views. – JK