In the dying days of 2016, the trade-weighted US dollar index closed at just under 130. It has been drifting steadily downward since. Tactically, we believe the market has gotten ahead of itself and that there is short-term upside available. But it could be a long time before we see that end-2016 high again. The buck is being circled by the bears.
This may sound counterintuitive a week after a fairly hawkish Federal Reserve press conference, with US short-term interest rates already higher than those in Europe and Japan.
Fed Chair Janet Yellen gave us the expected rate hike, a “dot plot” implying one more for 2017, and some new guidance on the plan to reduce the balance sheet this year. A week earlier, Mario Draghi at the European Central Bank indicated that euro short rates would not be going lower, but otherwise gave us a dovish assessment. There was no hint of tapering here.
Moreover, Yellen’s announcements came hot on the heels of an unexpectedly soft May inflation report that pushed the year-over-year headline CPI rate back below 2%. The dollar dipped and the Treasury yield curve added dramatically to its flattening trend. The Fed Chair assured us this would not blow her off course—and this was perhaps their key message.
Pretty much the only current number that would support monetary tightening in a normal rates cycle is the unemployment rate of 4.3%. But this is not a normal cycle, it is a “normalising” cycle. The objective appears to be to use the tailwind from strong financial markets as cover to head back toward a long-term average short rate of around 3%, almost regardless of fundamental data.
The market cannot turn a blind eye to those fundamentals, however. Short-rate differentials are important, but after a six-year bull market those expectations are likely already in the dollar exchange rate, with few marginal buyers left. That focuses attention on inflation and growth differentials instead, which do not favour the dollar.
Inflation has been subdued worldwide, but while growth expectations are being revised downward in the US, they are being revised upward in Europe. This partly reflects growing business confidence as the fog of political risk has lifted over the spring, most recently in the postponement of a general election and recent disappointments for the Five Star Movement in Italy. But Europe is also at an earlier point in its recovery, having been stuck deeper and longer in the mud to start with. The swift rescue of Spain’s Banco Popular this month underlines the robustness of that recovery. By contrast, while we envision performance improving for the US the next six months, our growth engine, the consumer, is tired—as a weak retail sales report on the day of the Fed meeting showed.
This has been evident in markets for some time. If we take the so-called “Trump trade” to mean strength in US versus non-US equities, relative strength in financials and small-caps, and a strong dollar, it’s been dead for months. Financials are lagging; large US companies with high foreign earnings are outpacing domestic businesses; all the talk is about Europe and emerging markets; and the dollar has floundered. As flows follow that performance out of dollar-denominated assets, that trend could gather momentum.
These are never straight lines. In our view, the Trump trade is now so thoroughly beaten up that any hint of legislative progress could give the dollar a lift. The market expects the Fed to proceed cautiously, pausing rate hikes while it makes its first balance sheet readjustments, so any more-aggressive move could offer support, too. On the other hand, with the yield curve already very flat, it could just as easily damage confidence and reinforce the fundamental signs of relative weakness that are currently posing the downside risk.
A tactical bounce is possible, then. Investors may get a chance to sell dollars at better levels than today’s. But a sustained comeback for the greenback looks highly unlikely as we move toward 2018.
Brad Tank, CIO — Fixed Income, Neuberger Berman