The much-ballyhooed rally in the USA dollar now “seems complete,” a Morgan Stanley FX Pulse research report opined. At a time when the US Federal Reserve is considering the beginning of the end of its more than $4 trillion balance sheet and interest rate increases are now less certain, “markets may now test if central bank reaction functions may have changed.” But global economies may trump the besieged reform agenda of the current US administration as central banks have the latitude to stay accommodative.

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USA Dollar

USA Dollar  - Global headwinds have turned to tailwinds

As the July heat of 2014 came into focus, a base was building in the value of the US dollar after a rally started near the 2011 quantitative period. The dollar index eventually rose in dramatic fashion over the course eight months, starting at 80 in July 2014 to touch 100 before the winter frost had lifted the following March.

The dollar then lobbed back and forth between near 102 and 92, engaging in shorter term monthly trends for nearly the next two years before moving in a decided downtrend that began in March 2017. That ride lower now puts the dollar index at short term support. It is here that Morgan Stanley essentially says the USA dollar is done.

“Global headwinds have turned into powerful tailwinds for the US, which may be important when interpreting the Fed,” Morgan Stanley’s Hans Redeker wrote in the report that stated the US dollar’s “long-term uptrend seems complete.”

Get ready for "super goldilocks" scenario

Being a central banker in the post-quantitative easing world can be difficult. Many traditional metrics showing economic growth, such as low unemployment, have not been confirmed by correlated rises in inflation. In part, this is creating an economic environment that is expected to be “just right” for a long period of time.

“Synchronized global growth, a weaker USD and globally low funding costs should not only support the US economy; they may also enable a ‘super goldilocks’ financial market scenario to take hold, provided that inflation stays low,” Redeker wrote at a time when the US is in the middle of withdrawing market supporting stimulus. This comes as the European Central Bank is considering raising real interest rates from negative as China is in the process of executing a beautiful deleveraging.

Redeker notes two different performance drivers impacting the US dollar rally.

Most recently, when the USA dollar rallied following the election of Donald Trump, “investors believed in an autonomous US growth impulse, increasing the attractiveness of the US as an investment destination.”

But the current performance drivers are very different from the past. Near the start of the quantitative era, it was global economies slowing and a deflationary bent that appeared to be driving the dollar higher.

In contrast, it is worth remembering that most of the USD rally witnessed from 2011 was instead due to external factors such as China slowing down, the EMU running through a string of deflationary shocks, EM countries falling into recession and commodity prices falling. All these events were of a deflationary nature, and it was only the progressive stance of ‘Abenomics’ that boosted the USD without also adding deflationary impulses.

Currently, the Trump administration agenda is a question mark yet corporate growth is humming along without much resistance, creating a “reality check.”  Redeker says that “relatively few” expect the US to see “a bullish, autonomous growth shock triggered by reform.”

In part, the lack of reform and fiscal stimulus may allow the Fed to react differently. On inauguration day, when it was assumed the Trump administration would be successful in unleashing the mother of all fiscal stimulus packages, the US central bank was reported to be casting a wary eye. With the Trump agenda now running into Congressional roadblocks, the central bank may be able to take a more dovish approach to interest rate hikes.

Citing “lagging reform momentum,” the current environment may actually increase the length of the current risk bull run.

Redeker sees two probability paths:

Growth outlook-enhancing reforms may initially be bullish, especially for USD-denominated risky assets, but it may push the Fed to give up on gradualism and instead engage in an accelerated tightening cycle, pushing nominal and real rates, and thus also the USD, higher. A rising USD would then bring the risk rally to an end.

But the outcome he thinks is more probable is a global economy “shifting into high gear” that is occurring without significant US reforms. “Animal spirits are on the rise” as many see the risk rally being driven by an accommodative central bank which may stay as such for a longer period of time.