Cant’ Seem to Decide

The market can’t seem to decide
If buying the buck’s justified
While rates are entrancing
The issue’s financing
Those deficits, which won’t subside

So cyclical forces point higher
But structurally there is a fire
Destroying its base
Which bears will embrace
Thus dollars they just won’t acquire

The overnight session has resulted in the dollar continuing to recoup the losses seen Monday after the President’s tweet regarding China and Russia’s alleged currency manipulation. If you recall, the market seemed to expand that into a generic sign that the US was seeking a weaker dollar. But since then, the dollar has performed ably, benefitting from ongoing data softness elsewhere and reasonably solid data at home.

The biggest mover overnight was the pound, which fell 0.65% after CPI was released at just 2.5% with the core printing at 2.3%. Both those outcomes were 0.2% below expectations and continue the trend of inflation heading back toward the BOE’s target of 2.0%. While that is clearly good news for the UK, the market has been forced to reprice the probability of future rate hikes. Although the probability is still high for next month’s meeting, at 84%, it has fallen significantly for the November meeting, from well above a 50% probability to now around 40%. And after all, if inflation is, in fact, under control and heading back to target already and the economy’s growth trajectory is flattening, it doesn’t seem that higher rates are necessarily the right prescription. The euro is also edging lower this morning after the final reading of CPI data there disappointed at 1.3% (exp 1.4%) highlighting the fact that the ongoing narrative regarding the ECB withdrawing stimulus seems to be ahead of itself.

It is with this in mind that I wanted to discuss the big picture for the dollar. There was an excellent short article on the Bloomberg service yesterday (“Time Is Running Out on the Bull Case for the Dollar”) which succinctly made the case for both sides of the argument regarding the dollar’s future path. In a nutshell, the cyclical case for the dollar (interest rates and economic activity) remains quite bullish while the structural case for the dollar (the US fiscal situation with significant budget and trade deficits) arguably points to further dollar weakness. And so the question is, which one will dominate.

As you know, my view has been the cyclical case is what drives the bulk of the market’s activity and it is why I continue to look for the dollar to rebound further from last year’s declines. Interest rate differentials remain quite attractive with, for example, the two-year spread between Treasuries and Bunds at 2.99% this morning (US rate 2.40%, German rate -0.59%) and so when it comes to the search for yield, the clear choice is dollars. Given that US rates are the highest in the developed world, that rate advantage exists against all of the other G10 currencies as well, albeit at various different levels. A potential dampener of that effect occurs if the investor is seeking to hedge the trade’s FX risk. The flattening of the yield curve in the US means that hedgers are forced to pay away much of that yield advantage to prevent FX movement from undermining their investment. But not every investor hedges, and in fact, many are seeking to maintain a USD exposure overall.

The second part of this case is the economic performance of each nation. Here, too, the US continues to outperform its G10 counterparts. While the overall global growth trajectory seems to have peaked, the data we have seen so far this year points to a more rapid slowing elsewhere in the world than in the US. Remember, too, that US fiscal policy has just been significantly eased between the tax reform and budget bills that were enacted in the past several months. Arguably, these ought to underpin a better growth story here than elsewhere. One way to characterize this is that the US is currently running tightening monetary policy (Fed rate hikes, balance sheet runoff) and loose fiscal policy (tax cuts, budget deficits). Historically, this combination of policy settings has always led to a stronger currency. I continue to believe this will be the case going forward, but there is another side.

The structural story is based on long-term capital flows and trends in a nation’s fiscal position. It is here where dollar bears make their case. By virtue of the fact that the US is back to running both a large budget deficit and a large trade deficit, the funding for these deficits needs to come from somewhere. That somewhere is the rest of the world. On the trade side, we send dollars to other nations to buy their wares and then they need to do something with those dollars. What they do is buy US securities, either Treasuries or equities or sometimes property. At the same time, by running a large budget deficit, we issue plenty of Treasuries for them to buy. So the bargain is we borrow from our suppliers of goods to buy those goods, kind of like vendor financing. Now since WWII, when the dollar became the world’s reserve currency, we have basically been able to do this with impunity, as essentially everyone would accept dollars. Lately, however, some have questioned the ability for this process to continue.

Finance professors will point to the idea that in order to make this equation work the dollar needs to decline to a point where it appears stable in a new equilibrium. As I have pointed out numerous times in the past, the dollar is currently right in the middle of its long-term range, so this is arguably not that new equilibrium. Rather, the dollar bears argue that the dollar needs to decline much closer to its historical low levels (think of the euro at 1.40-1.50 and the yen back at 85) in order to find a new equilibrium level. And that is the crux of their case, the dollar must head lower in order to reach a point where foreign investors are comfortable buying US assets on an unhedged basis.

In the end, the dollar’s future will depend on all of these things and the relative timing of changes in each variable. A saying in markets is that nothing matters until it matters. This means that while particular issues may be outstanding for a long time, until the market focuses on the issue, it is not going to drive trading or investment decisions. The long-term dollar bearish case is quite viable, it is just a question of what will cause it to ‘matter’. My view remains that the cyclical case will continue to dominate as US rates continue to rise and it becomes clearer that the rest of the world is going to continue to lag. And that should help the dollar overall.

At any rate, hopefully this helps make clear both sides of the argument ongoing in markets. As to today, the only data is the Fed’s Beige Book, which has consistently shown the robust aspects of the US economy and highlighted the ongoing price pressures most businesses are feeling. But until that is released this afternoon, FX is likely to take its cues from other markets and with Treasury yields continuing to edge higher and equities doing the same, I like the dollar to continue its two-day rebound.

Good luck