Another quarter has come to a close. The primary theme of this period centered around what would the Fed decide after months of deliberation. When September finally arrived, Ms. Yellen and her crew of cohorts gulped hard, decided to eat crow, and backed away from an interest rate hike that many, including the IMF, had regarded as premature. Now we must wait again and endure another period of anticipation and with it, uncertainty.
As for the U.S. dollar, we can expect another gradual round of appreciation as the Fed dithers about for another quarter...or can we? The historic run up of the USD from May of 2014 through March of the present year has been nothing short of phenomenal, but wary economists also predicted a modest pullback in domestic exports as a result of our strengthened national currency. While the greenback rushed ahead and settled about a 20% growth factor, exports did not begin to decline until the beginning of 2015, falling roughly 6% to date. Is more to come? Will falling exports punish the Almighty Dollar?
At some point, the Fed will relent and take action with programmed rate hikes. A review of the historical record reveals a common repeating pattern, one where the dollar appreciates before the rate hike and then falls afterward, a typical “sell after the news” scenario. The unrelenting strength in equities would seem to suggest that the economic stage was set for another Bull run, but we have to accept that the USD has benefited for another reason. Global currency wars against the dollar are in play. Of the top twenty central banks in the world, all but Brazil have been reducing interest rates, and nearly a majority of those have pushed rates below 1%. Switzerland and Sweden are negative.
How did the majors perform over the last quarter?
As one might expect, King Dollar has settled into a well-defined range since last March. Its index has bounced between 93 and 98 for months. It fell 2.3% last quarter, and then recovered 2.5% thereafter. As equities rejoice that cheap money is still on the table, the USD index recently returned to the 94 level, but analysts still expect it to hit 100 by year-end. Here are the appreciation results for the quarter ended September 30, 2015:
Although the dollar appreciated during the previous quarter, it was by no means across the board. The euro and yen both rebounded slightly, while the pound and the Aussie took it in the shorts. Yes, divergence in central bank policy is still the driving force that moves major currency pairings, but there is a bit more going on behind the scenes. The ECB and BoJ are both expanding their money supply, a strategy designed to weaken their respective currencies, but in both cases the market adjusted in the opposite direction. Forex analysts point to the wariness of the Fed to act as the reason for these two anomalies. There are no economic successes in either region to justify such moves.
Sterling is another story. In most circles, the pound has been seen as a “caboose” of sorts, tagging along behind the USD train. If the Fed acted, most would have expected the BoE to jump on board with its own interest rate adjustment upward, but something went astray. Recent economic data for the UK did not support a change, and so, depreciation was in order.
The fall of the AUD, however, is tied to China’s travails. Chinese officials are learning that controlling an economy on the way down is quite another proposition than encouraging growth on the sidelines on the way up. Miss-steps will be made. Trading partners, as well as all emerging market economies, will suffer as a consequence.
Will King Dollar abdicate its throne in the final quarter of 2015?
Timing is truly everything, when you try to forecast what will transpire over the remainder of calendar 2015. The Fed’s reputation has been tarnished, after balking at a rate increase that they had been telegraphing for months to the world at large. If you piece together recent speeches by various Fed members, there seems to be confusion in the ranks. Ms. Yellen will have a difficult task, gaining consensus from her compadres in the months ahead. The current thinking is that December is the decision point meeting. Non-Farm payroll data from November will then be a key determinant in that debate.
At present, forex experts are once again predicting action. If you accept their premise, then a small ramp-up of the greenback—based on the expectation of a rate hike—will repeat last quarter’s scenario. We will witness a similar appreciation, as noted below:
The euro and yen will give back their recent gains, while the pound and the Aussie stand firm. The logic supporting this forecast is summarized by the following bank analyst:
“The US dollar (USD) remains in high demand, supported by attractive growth and interest rate differentials vs. major peer currencies. The Fed’s clear intention toward policy normalization, its data dependent stance, and the strengthening pace of US activity should serve to reinforce the global theme of economic and policy divergence and provide for continued USD strength.”
With a 2.75% positive wind behind its sales, what might cause the dollar’s ship to run aground? Timing is the big question mark. Economic data in Europe and Japan are not trending as expected. Both central banks will be reviewing their respective stimulus plans and looking for more ways to encourage growth and inflation to reappear. All things considered, if the Fed blinks again, the market may not be as generous as it was before. In that case, a dose of depreciation may be the order of the day.
What insights can be gained from a review of the USD Index?
As the U.S. Dollar consolidates its position versus other major pairings, the USD Index may offer up a few more insights worth revealing. This index may not reveal the full story, since it does not record the continuing flight of capital from emerging markets that has been taking place for a year or more. Since 2011, the trade-weighted USD index has appreciated some 27% versus a mere 19% for the major-focused USD Index. Restoring confidence in the emerging investment area is another issue altogether. As for the USD Index, here is a current chart:
The dollar is clearly range bound, with well-established support at the 38.2% Fibonacci level. Poor retail sales data has created one more test of that level and a familiar pattern for all forex traders – a possible “Head-and-Shoulders” formation. Whereas this H&S pattern may appear here in a daily chart, a similar one appears in the “EUR/USD” hourly chart, in favor of the USD. This pattern appears so frequently that it is difficult to follow this weathervane, without confirmation. December, however, is a long way away. Anything could happen in the interim, including a weakening down to the 61.8% Fib line.
Forecasts for the year-end for the consensus of banking forex departments still hover around “100”, as depicted on the chart. Volatility has subsided since March, and the recent sell-off seems to be overdone, if the readings of the Slow-Stochastic indicator are to be believed. Before we leap to any other conclusions, let’s not forget the composition of this index:
- Euro (EUR), 57.6% weight
- Japanese Yen (JPY) 13.6% weight
- Pound Sterling (GBP), 11.9% weight
- Canadian Dollar (CAD), 9.1% weight
- Swedish Krona (SEK), 4.2% weight
- Swiss Franc (CHF) 3.6% weight
Based on demographic shifts over the past two decades, these weightings appear to be a bit out of date. Europe is over represented, and Asia, without the Aussie dollar, seems terribly under-weighted with only the Japanese yen to speak for the region. In any event, it is what it is. The question remains – What is in store for both the near and long-term?
Banking analysts have already drawn their line in the sand, with a target of “100” by the end of 2015, based on the Fed taking action. There are quite a few experts, however, that make a convincing argument that the Fed will drag its feet again, thereby setting up a scenario for a fall in the index, especially if the U.S. economy sputters at any point in this long-drawn out process. The domestic economy, however, has remained stable. Through June, GDP growth was up an annually adjusted figure of 3.9%, and recent inflation data hit 1.9%, just below the Fed’s target. So far, so good.
The Conference Board, a global, independent research association, has already forecast the U.S. economy to firm up around 2.5% for GDP growth for 2015, such that there are no real signs that a recession could be in sight. But can the U.S. economy be enough to pull the rest of the world along with it? Exports are clearly declining, while imports are rising, thereby creating a double-whammy of sorts for the U.S. trade deficit. The Fed remains risk averse, in that they do not want to cause market volatility with a rate hike, as has happened many times in the historical record. Lastly, we have Fed board governors in disarray. Can Yellen gather together a consensus by the end of the year?
Concluding Remarks
Uncertainty can certainly make markets interesting, but not as much as when it is the result of central bankers publicly disagreeing with one another. Divergence is taking on an entirely new meaning. If you believe the futures markets, then they are looking to December or the first half of 2016 for the Fed’s initial move. If more delays are in store, then all eyes will shift to Europe and Japan for guidance on the value of the USD. Both of these central banks, however, like to take their time, waiting even longer periods to reach consensus.
Neither Europe’s, nor Japan’s, respective economies are within eyesight of the growth in the United States. More stimulus in the form of quantitative easing may be the potential outcome. China and Australia could also weigh in with reserve and rate cuts to boost their domestic efforts, thereby joining the broadening ranks of easing central banks across the globe. The central banking theme of policy divergence is alive and well, but the Fed is by no means in control of the action. They have chosen to take a back seat.
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