Much ado about nothing much
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?