Falling oil prices, China growth fears, submerging markets, Brexit and Italian banks. All of those risks have one thing in common: They have not derailed the US economy. Despite concerns about a recession, it continues to grow at a steady pace. According to the Atlanta Fed, real GDP is expected to grow by 0.7% in Q1’16. That is not a great number; however, the series is extremely volatile.
sources: Bloomberg, @Not_Jim_Cramer
It would not be surprising to see growth rebound to 2% or more in the coming quarters.
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Global investors are counting on the US because of lackluster growth elsewhere. Europe is doing fine; however, deflation remains a concern and bank credit growth is turning down. Japan continues to fall in and out of recession. In the emerging world, the BRICs are crumbling. Brazil & Russia are suffering due to falling commodity prices while China continues to decelerate. Going forward, rate differentials, relative economic strength and divergent monetary policies should provide support for the USD.
Sentiment & Positioning
With all that said, as of Mar29’16, the net speculative long position in the USD was 7% of open interest, the lowest it has been since Q2’14. This indicates that speculators are the least bullish they have been in nearly two years.
The US Dollar Index is sitting at 94.62, just above a critical support zone at 93-94. Meanwhile, the Trade-Weighted Dollar Index has pulled back ~3.4% from its high on Jan20’16. It is hard to tell that long USD is a consensus trade because investors have lost their conviction.
FX, Rates & Monetary Policy
USDCAD: Has fallen to 1.3011 from a high of 1.4692 on Jan20’16. This is a direct result of the relief rally in oil, which has risen to $36.79 from a low of $26.05 on Feb11’16. These moves have not been driven by improving fundamentals. Rather, they are mostly attributable to short covering.
Rate differentials (see the following chart), relative economic strength and divergent monetary policies should support USDCAD in the near term. Also, it is unlikely that the bear market in commodities is over.
sources: Bloomberg, @sobata416
EURUSD & USDJPY: In Europe and Japan, easy monetary policy will be present for an extended period of time. The ECB and BOJ have made it clear that they will do “whatever it takes” to protect their countries from deflation. The ECB recently announced a set of new measures intended to support the Euro Zone. Equities have responded positively but the Euro has not. EURUSD is trading at 1.1389, up from a low of 1.0538 on Dec3’15. Japan is facing the same issue. Even though Japanese equities are up since oil bottomed on February 11th, the Yen is the strongest it has been since Q4’14. It is unlikely EUR and JPY strength will persist for the same reasons mentioned in the previous paragraph.
World Reserve Currency
The USD is the most widely held reserve currency in the world. It represented 64% of official foreign exchange reserves at the end of Q3’15. Countries tend to hold Dollar-denominated assets because they are relatively stable. Foreign central banks also use the USD as collateral for loans and to protect their currencies. For example, if the ECB feels as though the EUR is too strong, it can sell Euros to buy Dollars, thereby reducing the amount of USD in circulation. In theory, this would weaken the Euro.
The foreign exchange market also speaks to the structural importance of the USD. According to the BIS’ Triennial Central Bank Survey, “FX deals with the US Dollar on one side of the transaction represented 87% of all deals initiated in April 2013.”
Lastly, it is important to recognize that many commodities are priced in USD. Therefore, people who want to buy or sell them are required to hold Dollars.
These facts help to explain why demand for the USD will persist. It is still the world reserve currency and that will not change in the near future.
The two major risks to the USD are a dovish Fed and slowing US economic growth.
The Fed is the world’s central bank. Even though both of its mandates are domestic, the Fed has become increasingly concerned about the global economy. This is evident when we look at the rising number of times the Fed has mentioned key terms such as “Global” and “Dollar” in recent meetings.
A strong USD is good for US consumers and bad for commodities & exporters. The Fed is well aware of this relationship; however, it alone does not guarantee dovish monetary policy. Not long ago, market participants thought that 4 rate hikes in 2016 was a possibility. Now, it is unclear whether or not we will see 1. As of Mar29’16, the probability of a hike in December was just 65%. The market is positioned for easy US monetary policy. As such, positive surprises from the US or negative surprises out of Europe or Japan will force investors to reassess their outlooks. If that happens then the Fed may turn more hawkish, which would be positive for the US Dollar.
2) Slowing US Growth
The US economy continues to muddle along, backed by steady employment and consumption growth. The Eurozone is doing fine but most of its gains are attributable to Germany. Other major players such as France and Italy have not fared as well. Moreover, Japan continues to tread water. Canada has rebounded. That said, its economy is dependent on commodity prices, which may roll over in the short run.
All in all, the US still looks good on a relative basis. Especially versus developed market peers.
Return of the King
Rate differentials, relative economic strength and divergent monetary policies should provide support for the USD. In addition, it will likely benefit from safe haven flows when global risks return to the headlines.
If the Dollar resumes its uptrend then commodities will suffer.
Oversupply in many industries such as oil, iron ore and coal remains an issue. On the demand side, China’s deceleration is not helping. The emerging markets are inextricably linked to commodities. If prices fall then the EMs will underperform.
There can only be one king…
– This material is provided for informational purposes. It is not investment advice.
– The opinions expressed in this report are mine. They do not reflect the opinions of my employer.
– Full disclosure: As of Apr3’16, I was long the USD vs. the CAD & a basket of EM currencies.