The Fed and dol­lar de­pre­ci­a­tion

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

So no sur­prises. A slightly more dovish Fed­eral Open Mar­ket Com­mit­tee stuck to the script of fu­ture mon­e­tary pol­icy moves be­ing data de­pen­dent.

Since the US cen­tral bank last week scaled back its 2015 GDP growth forecast to 1.8%-2%, the im­pli­ca­tion is that rate in­creases, even if they start in Septem­ber, will be a grad­ual af­fair.

In­vestors liked what they heard as this sug­gests that Goldilocks lives, and a “not-too-hot, not-too-cold” sce­nario re­mains pos­si­ble for the rest of the year—the S&P 500 rose 0.2%, 10-year trea­sury yields fell to 2.27% and the DXY dol­lar in­dex drifted lower by - 0.9%. We think the mar­ket got it about right, and the dol­lar will con­tinue to trend lower on a soft­ish growth out­look.

The cut in the Fed’s 2015 growth forecast from an ear­lier 2.3-2.7% partly re­flects the soft patch in 1Q15. But Janet Yellen was also clear in stat­ing that ne­t­ex­ports have been a big drag. We think this is largely due to the strong US dol­lar, which will re­main a headache for US pro­duc­ers. It is clear that the rise in the dol­lar’s real ef­fec­tive ex­change rate since 2011 is now caus­ing real pain for the US trad­able sec­tor, es­pe­cially man­u­fac­tur­ing.

Even as the prop­erty mar­ket perks up with the on­set of sum­mer, there is lit­tle sign of any re­cov­ery for me­tal bash­ers. US in­dus­trial pro­duc­tion for May fell by -0.2% MoM, so there is lit­tle chance of a 2014 re­peat, when both man­u­fac­tur­ing and ser­vices picked up steam in the sec­ond half af­ter a slow start to the year.

Last week, our an­a­lyst Charles ar­gued that his key in­di­ca­tors were of­fer­ing an al­most en­tirely neu­tral read­ing, but he tended to­ward a neg­a­tive view, im­ply­ing US dol­lar strength. To­gether with US economist Will Denyer, we tend to have a mildly more op­ti­mistic view, which sug­gests the DXY is un­likely to rally sub­stan­tially. History, of course, tells us that a fur­ther dol­lar spike can­not be ruled out, but any gains will ren­der the US even more un­com­pet­i­tive, in turn forc­ing the Fed to keep pol­icy loose.

In the ab­sence of eco­nomic over­heat­ing, the chances of the Fed be­ing pushed into ac­cel­er­ated rate hikes is low. For this rea­son the softer growth out­look sug­gests that the even­tual rate hike tra­jec­tory will be more gen­tle than might rea­son­ably have been as­sumed at the start of the year.

By con­trast, the Euro­pean economies are show­ing in­creased signs of re­fla­tion as cor­po­rate lend­ing and cross­bor­der credit flows con­tinue to im­prove. As such, we think the pen­du­lum in cur­rency mar­kets will swing back in favour of the euro. Af­ter all, the dol­lar rally, which started last year, was driven by a sharp di­ver­gence open­ing up be­tween a grow­ing US and de­flat­ing eu­ro­zone. With those dy­nam­ics hav­ing gone into re­verse, cur­rency mar­kets are likely to ad­just.

As for tim­ing, the “dot plot” made by FOMC mem­bers in­di­cates that a US rate hike will come sooner rather than later (we re­ally have no in­sight as to which month). How­ever, the ex­pe­ri­ences of the last four rate hike pe­ri­ods has been for the DXY to de­pre­ci­ate in the pe­riod fol­low­ing the lift-off in rates—we ex­pect a re-run this time around.

The Yellen Fed has thus far man­aged to shape ex­pec­ta­tions with­out caus­ing big shocks, and so the chance of a 2013-style “ta­per tantrum” ex­pe­ri­ence, sparked by a sud­den shift in com­mu­ni­ca­tion, seems less likely.

So long as this pat­tern con­tin­ues to hold, then both the fun­da­men­tals and the in­sti­tu­tional pro­cliv­i­ties of this Fed point to the dol­lar hav­ing likely topped out.

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