Much ado about noth­ing much

Financial Mirror (Cyprus) - - FRONT PAGE - By Louis Gave

A quick glance through the fi­nan­cial me­dia would lead the ca­sual ob­server to con­clude that the US cur­rency has been, and re­mains, in a bull mar­ket. Af­ter all, with the Fed­eral Re­serve now sup­pos­edly back on a tight­en­ing track, how can the US dol­lar fail to rise? This almost uni­ver­sal be­lief makes the re­cent price ac­tion all the more in­ter­est­ing for, let’s face it, ev­ery­thing that could have gone right for the US dol­lar in the past year has gone right: mas­sive eas­ing from the Bank of Ja­pan, rule-break­ing from the Euro­pean Cen­tral Bank, com­plete melt­downs in Latin Amer­ica, un­cer­tainty sur­round­ing China, ris­ing geopo­lit­i­cal ten­sions in Asia, and civil wars in the Mid­dle East. Yet to­day, the US dol­lar’s DXY in­dex stands be­low where it was three months ago, and even a year ago. For all in­tents and pur­poses, the US dol­lar has been range-trad­ing since Fe­bru­ary 2015.

On a re­cent trip to the US, I was re­peat­edly told that this in­abil­ity of the US dol­lar to break out on the up­side was en­tirely be­cause the mar­ket had ratch­eted down its expectations for Fed tight­en­ing. At the be­gin­ning of the year, most Fed watch­ers ex­pected two to three rate hikes over the course of 2016. As those expectations dropped back to just one rate hike, or even none, the US dol­lar strug­gled, mak­ing a se­ries of lower highs and lower lows through the early months of 2016. Sig­nif­i­cantly, the sole cat­a­lyst for the US cur­rency’s lat­est rally off of its May 3 low has been the re­newed hawk­ish­ness of the Fed; re­newed even in the face of weak durable goods or­ders, weak­ish em­ploy­ment data, neg­a­tive in­dus­trial pro­duc­tion num­bers and lead­ing in­di­ca­tors that have not stopped fall­ing since Jan­uary 2015.

As a re­sult, it will be highly in­struc­tive to see what hap­pens to this Fed-led rally over the com­ing weeks. There are three pos­si­ble sce­nar­ios to look for­ward to:

1) Up­com­ing US macro data con­tin­ues to dis­ap­point (per­haps be­cause most en­trepreneurs’ an­i­mal spir­its have been crushed by the unin­spir­ing US po­lit­i­cal cir­cus and the con­se­quent un­cer­tain­ties sur­round­ing the min­i­mum wage, health­care costs, cap­i­tal gains taxes, fi­nan­cial reg­u­la­tion etc.). In re­sponse, the Fed de­cides to sit on its hands af­ter all. In this, it would be fol­low­ing the path trail-blazed by cen­tral banks in Sweden, Nor­way, and New Zealand, which, af­ter sound­ing hawk­ish amid the 2010 re­bound, quickly re­versed course and slashed in­ter­est rates again. Un­der this sce­nario, the US dol­lar would most likely head lower, since the rea­son ev­ery mar­ket par­tic­i­pant is cur­rently bullish is the “hawk­ish” Fed.

2) The Fed tight­ens this sum­mer and pre­pares the ground for a De­cem­ber hike. To the mar­ket’s sur­prise, the US dol­lar does not go up, but con­tin­ues to trade side­ways in a broad range. This is the sce­nario mar­ket par­tic­i­pants have the tough­est time get­ting their heads around, even though it seems to be the one that is now un­fold­ing. Af­ter all, if the past month was one of “re­set­ting Fed tight­en­ing expectations”, all the mar­ket could muster was a 2.8% rally in the DXY from its lows—a rally which only brought the DXY back to its lev­els of late March.

3) The Fed tight­ens, sounds hawk­ish, and the last month’s US dol­lar rally marks the start of a new bull mar­ket, with new highs set be­fore the end of the year.

From re­cent client meet­ings, it seems almost ev­ery­one is ei­ther ex­plic­itly or im­plic­itly tak­ing the view that sce­nario three is the most likely out­come, and is over­weight­ing US growth stocks and US yields, and un­der­weight­ing emerg­ing mar­kets. Yet for the last year, mar­kets have failed to jus­tify this US dol­lar bullish­ness. If the Fed now be­comes more hawk­ish, and the US dol­lar fails to break out of its cur­rent pat­tern of lower highs and lower lows, then the bullish­ness will start to wane.

Over the last year the US dol­lar has be­haved like a stock that no longer goes up on good news, i.e. a stock ev­ery­one al­ready owns. And if it fails to gain on good news, how can the US dol­lar rally mean­ing­fully from here?

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