Dollar seen under pressure heading into Q2

Report prepared by Ahmed Shibley

The US Dollar took a dangerous tumble through the first quarter, throwing into doubt the currency’s ambitions after more than four years of advance. The extreme contrast between the Greenback and its global counterparts has notably moderated over the past months and that in turn has cooled the bullish fervor for the currency. In fact, the benchmark’s fundamental supremacy started to falter around March of 2015 when forecasts for growth, revenues and rates started to fall short of the overzealous speculative projections. As the economy cooled, corporate profits ebbed and the Federal Reserve cut its rate forecasts; the inflated Dollar premium started to evaporate.

In turn, the speculative chase for long-Dollar exposure cooled – as can be seen in the net speculative futures positioning below. Heading into the second quarter, the perceived advantage to the world’s largest currency and economy will likely remain under pressure. However, where the USD tempo may ease; its fundamental advantage is unlikely to falter. This will intensify the importance of and reaction to key event risk, bolster volatility and likely sabotage efforts to sustain major trends.

While the Dollar has maintained its bullish course, momentum started to flag approximately a year ago. Following a record-breaking 9 consecutive month climb for the ICE Dollar Index, the currency stalled and corrected through April and May. A key source of this slip was a souring of the market’s rate forecasts. In an effort to acclimate the market and temper the impact normalization would have on the markets, the Federal Reserve committed to a communications plan that emphasized forward guidance as an active tool. Yet, as their tone softened and the first rate hike (‘liftoff’) was expected to be pushed further back; the market applied the brakes to the Dollar’s advance.

Consistent

On a streak of seemingly consistent ‘downgrades’ for the central bank’s rhetoric and outlook, the market developed a near permanent sense of skepticism. We can see this incredulity in the chart below which shows the FOMC’s year-end-2016 outlook for interest rates (from the ‘dot plot’) generated from the median forecast amongst the members issued at the quarterly meetings compared to the market’s expectations derived from Fed Funds futures used to hedge the risk of rate changes. Clearly the market has persistently discounted the central bank’s expectations – and for good reason as they have had to downgrade. However, after the first hike in December, the Fed’s downgrade on rates to only 50bps (two hikes) in 2016 and market forecasts hitting zero; there is little room to further discount. Even the dovish members of the central bank believe 50 bps is reasonable. A hike is likely in 2016 and June is considered a conservative time frame. Given the market’s positioning, the ‘surprise’ of a hike could leverage a much larger reaction than an extended pause.

Many FX traders come from other asset classes that are heavily biased towards buy-and-hold or long-only mentality (such as equities). However, everything is FX is relative. If we were to consider the Dollar to its own historical circumstances, it would be a stretch to consider the Fed’s position as ‘hawkish’. We have only realized one rate hike, future rate hikes are heavily contested and the massive balance sheet inflation through multiple QE programs has been maintained. That compares to periods when rate hikes were not only successive but moving at much larger clips than the 25 bps standard. Yet, we aren’t comparing the Dollar to itself. Rather, we establish its value relative to other currencies.

When we look at the circumstances surrounding the benchmark currency’s most liquid peers, the contrast is significant. The ECB and BoJ are in the midst of large quantitative easing programs and have adopted negative rates.

The PBoC and SNB are threatening to move further into the unorthodox. Even the central banks of the currencies that have stood as carry pilots in the past (AUD, NZD and CAD) are still undermined by the warning of possible further rate cuts moving forward. If these counterparts continue to suffer greater distrust – whether through monetary policy, economic performance, financial risk, etc. – than the US, the Dollar will likely find incidental demand in fundamental valuations.

A final fundamental word for the Dollar on perhaps the most underappreciated aspect of its value: The US Dollar represents the world’s largest economy and financial system. This position has led global investors over the past years and decades to impart upon the currency a presumption of a robust haven status. In this most recent global economic phase, the Greenback has deviated somewhat from this role as its early shift to normalize monetary policy has imbued it with something of a ‘carry trade’ (or risk) appeal. However, where the currency has slipped amid periods of risk aversion as the front-running carry trade is unwound; this unusual position will not hold up against a definitive de-leveraging of risky exposure. If the assets of the global financial system that have an orientation to growth and higher return tumble in concert, the intense risk aversion will quickly restart the Dollar’s haven status.

Coming into Q1’16, our main theme for EUR/USD was that, because market participants would be wholly fixated on seeing what the European Central Bank and the Federal Reserve would do in their March meetings, neutrality would prevail. Indeed, with price ranging between $1.0710 and $1.1376 over Q1’16, we believe the sideways trading environment anticipated did indeed play out. With that said, we’re reiterating our belief that, due to the lack of a clear divergence in monetary policies coupled with a vague technical backdrop, EUR/USD is due for more sideways trading.

Expectations

While there may have been passive expectations for the ECB and the Fed to step up their stimulus offerings at some point in Q1’16, the steps taken in March by both central banks were deemed surprising by markets. Consider that the ECB’s March easing efforts weren’t aimed at FX rates, and the Fed’s hold eliminated two rate hikes from their ‘dot plot’ in 2016. Even though the ECB unveiled measures to ease credit channels and thus, make policy more dovish at the margin, the explicit rate divergence trade had seemingly taken a backseat thus far in 2016 without a Fed rate hike year to date.

Granted, in Q2’16, it seems unlikely that both central banks move – and if one is to move at all, it’s going to be the Fed. In that regard, it seems the Fed is trying to shape expectations for an April or a June rate hike; although the Fed, like the ECB and so many other central banks, has fallen into the predictable pattern of only making significant decisions when armed with changes to their staff policy forecasts in hand. We surmise that the Fed won’t want to raise rates without Chair Janet Yellen being able to defend the decision at a press conference, so June seems the most likely period.

For the ECB, there are a few factors in play. For starters, we can’t dismiss that ECB President Mario Draghi made clear that he along with other members of the ECB Governing Council believe that the FX channel has become less receptive to ECB easing measures. While EUR/USD is hovering the ECB’s 2016 technically-assumed level of $1.0900, it appears that the ECB will be willing to tolerate a stronger exchange rate so long as it doesn’t interfere with inflation pressures picking back up.

There’s also something to be said about the voting composition at the ECB meeting in March, and why that means the ECB won’t ease again this quarter. Jens Weidmann, the notorious German policy hawk who heads up the Bundesbank, did not vote at the ECB’s March meeting due to the recently instituted rule of rotating voting members. Call us conspiracy theorists, but given Mr. Weidmann’s public admonishments for the ECB’s March actions, we’re led to believe that his presence during future votes means the threshold to ease further will have to be higher.

What may be the biggest risk to the Euro in Q2’16? The EU-UK referendum on June 23 (and the extremist innuendo that’s led to the referendum in the first place). Based on the media reaction, the particular mechanisms of the voting process and events thereafter aren’t well-known, which has led to heightened volatility in markets. Let’s be honest – the likely economic and political outcomes for the UK are not all that enticing to discuss because they don’t pander to people’s insecurities and fears.

If markets are overreacting regarding the British Pound, they’ve underestimated this event in terms of the existential implications it has for the Euro by a very wide margin. The whole premise of the European Union project, going back to its humble beginnings rising from the ashes of World War II as the European Coal and Steel Community, was to promote an economic vision of a unified Europe where, regardless of the language you spoke, the country you lived in, or culture you partook in, you were a European at heart. When we fast forward to present day, the implications of a Brexit at a time when (1) a crippling debt crisis has sapped sovereignty from peripheral European countries, (2) the Syrian Civil War has produced an uncontrollable wave of refugees that has revealed infrastructure issues and (3) considerable security concerns to the point that countries have threatened to renege on their Schengen Area duties to close their borders.

The Euro is having a “political moment” right now. The very heart and soul of Europe is at stake from a litany of perspectives. This may be a disagreeable statement, so we defer to German philosopher Arthur Schopenhauer: “All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being selfevident.” If the world wakes up June 24 and the UK has voted to leave the EU, the Euro will have some difficult truths to deal with indeed.

Gold embarked on an aggressive recovery in the first quarter of 2016, buoyed by a slump in Federal Reserve rate hike expectations. A dovish shift in investors’ policy bets reduces the opportunity cost to owning gold versus interest-bearing assets while boosting demand for alternative stores of value to hedge against increased inflation risk. Prices traded to just shy of the $1300/oz figure, hitting the highest levels in over a year.

When the Fed projected 100bps in 2016 tightening following post-QE rates “liftoff” in December, traders priced in just 50bps. As the calendar turned to 2016, the prospect of a more hawkish central bank than had been accounted for in asset prices triggered risk aversion. Dropping stocks – a proxy for broader sentiment trends – echoed into priced-in Fed views as investors questioned whether policymakers will make good on stimulus withdrawal amid market turmoil. After briefly dropping rate increases from the outlook entirely in February, traders settled on one 25bps increase before year-end.

Fed Chair Janet Yellen and company responded by slashing the projected rate hike path to imply two 25bps hikes this year. Subsequent comments from central bank officials offered a relatively upbeat tone on domestic prospects and cited external forces including the slowdown in China as the rationale for opting for a more cautious stance. Taken together, these moves may imply a new strategy aimed at realigning official and market-based rate hike bets, presumably aimed at setting the stage for a smoother hike in June.

Indeed, the case for tightening remains compelling. The unemployment rate has dropped to 4.9 percent, the lowest in eight years. Meanwhile, the Fed’s favored core PCE inflation gauge showed price growth accelerated to a three-year high of 1.7 percent year-on-year in January. Critically, this happened before headwinds to price growth eased as the US Dollar weakened and crude oil prices rebounded in February, meaning the Fed’s 2 percent target is probably even closer to being reached.

Realized US economic data outcomes have steadily improved relative to consensus forecasts since early February. More of the same coupled with a coordinated Fed communication effort aimed at smoothing the normalization process boost the priced-in policy outlook. This is likely to cap gold’s advance and push prices lower, painting recent gains as corrective within the context of a multi-year down trend initiated in late 2011.

Oil has stayed resilient during the past few weeks, despite occasional riskoff sentiment. Crude prices rose to their highest in three months in early March, at $42.49/barrel for WTI and $42.54/barrel for Brent. This was triggered by a combination of tightening supply, a proposed production freeze and a weaker US dollar. However, the November-December range of $44.16-$46.46 may act to cap higher development in WTI oil in the near term. Looking ahead, the April 17 Doha meeting to freeze output is a main event for the supply side, whereas demand growth from the main consumers may continue to slow down.

Global oil supplies diminished by 180,000 barrels per day in February, according to International Energy Agency’s March report, although the pace of reduction has been painfully slow. Within the OPEC group, decreased output from Iraq, Nigeria and the UAE was offset by a rise in Iran’s production after sanctions were lifted. In the U.S., shale oil producers recently halted their cuts of active rigs, according to Baker Hughes Inc. This pattern will likely continue in the foreseeable future, unless an accord to freeze output is reached at the upcoming producers gathering. Qatar has successfully arranged a meeting among OPEC members and other major oil producers to cap their production at January’s levels, in order to reduce the supply surplus. At the time of writing, Qatar’s Minister of Energy and Industry confirmed attendance by 15 countries within and outside OPEC, with the self-exclusion of Iran and Libya. If this meeting does not come to fruition, similar recommendations would likely be discussed at OPEC’s semiannual meeting on June 2.

Supplies from major producers have built up over the years, according to statistics by the International Energy Agency. However as low oil prices take their toll on upstream investments, plunging supply growth could eventually lead to a price recovery.

Oil has had a significant turn-around since WTI Crude Oil printed 26.03 on February 11. Since that low, Oil is higher by nearly 61% or $15.91/barrel as of the late March high of $41.90/barrel. In a month, Oil bears went from looking like market masterminds to fools because of the 60%+ rise. However, there is still much uncertainty as we approach the key chart-pivot of the 200-Day Moving Average that currently comes in at ~$42/barrel. The 200-DMA is where WTI Crude Oil has turned lower in June & October and is now verified as longterm chart resistance. Additionally, the US Dollar weakness that is negatively correlated to Oil could further support of the world’s most necessary commodity. Lastly, RSI (5) on a daily chart recently hit its highest level since early 2014, which may argue we’re getting carried away as we head into technical resistance.

As we entered the New Year, it became obvious that the lack of further Central Bank support in December threatened the fragile recoveries that have been seen around the globe in the post-Financial Collapse environment. The European Central Bank had talked up more QE leading into their December meeting, and that fell flat on December 3rd when the bank failed to increase their QE program, and instead merely cut the deposit rate into deeper negative territory. The Bank of Japan avoided any additional stimulus actions in December, and we even saw an actual rate hike out of the Federal Reserve. So in one sense, it appeared as though we were nearing the end of the ZIRP-fueled environment that reigned across global markets for the past seven years. But that feeling of strength did not last for long.

The reverberations were felt near-immediately on the open of the New Year. The concurrent pain factors of an Asian slowdown while full-fledged carnage was taking place in commodity prices was too much for the world to bear in a tighter (or less loose, even) monetary environment. It only took six weeks of pain before we saw Central Banks begin to bend to the pressure. The lows across many markets were set on February 11th, which was the second day of Ms. Janet Yellen’s Congressional Testimony. And while she didn’t say anything directly assertive regarding interest rate policy or QE, she did provide enough confidence to financial markets that the Fed would remain supportive while global risk factors were flaring.