The Federal Reserve's real broad trade-weighted dollar fell for the first three months of 2017 and the greenback's heavy tone this month has raised questions about the state of the bull market. Despite this recent weakness, we think the bull market is intact and that the advance will resume.
In the February through April period last year, the real broad trade-weighted measure of the dollar fell. Many investors doubted the bull market was intact. The greenback proceeded to rally seven of the following eight months. In 2015, this measure of the dollar fell in three of the 12 months, two of which were back to back (April and May). In 2014, there was a three-month losing streak (March-May). It then appreciated in six of the following seven months. Of course, history does not repeat itself.
The Great Graphic depicts the real broad trade-weighted index (white line) and the euro (yellow line). The chart goes back to 1990. I am uncomfortable showing two time series on two scales on a single chart, as this practice seems abused on Wall Street. However, the two track each other pretty closely and for good fundamental reasons. Europe is a significant US trade partner and shares many of the same drivers of headline inflation, like energy.
To assess the dollar's bull market in a disciplined fashion, and to avoid getting caught up in short-run disruptions, we come back to our assessment of the driver. We argue that the first significant dollar rally post-Bretton Woods (the Reagan dollar rally) was driven by the mix of loose fiscal and tight monetary policies (under Paul Volcker). The second dollar rally (Clinton dollar rally) was driven by the birth of the internet, which ultimately led to a bubble. We note that the Fed began raising rates in 1994 and the dollar's bull market began in the spring of 1995.
We see the current dollar rally (Obama-Trump) as USD's third since Bretton Woods. What allowed us to anticipate it was our understanding of the driver: Divergence of monetary policy broadly understood. The Federal Reserve responded early and aggressively to the financial crisis. It began its unorthodox policies in 2009, several years before the Bank of Japan and the ECB began their efforts. This, coupled with the flexibility of the US economy, produced results earlier, allowing the Fed to exit and begin normalizing policy before most of the rest of the world.
The question of the state of the dollar bull market is a question, in our mind, of whether divergence remains intact. We think it does. Softer Q1 GDP, with the pullback in consumption, we see as a temporary soft patch. Growth in the January-March period has been typically soft beginning in 2010. From 2010 through 2016, growth in Q1 has averaged 1.1%. Growth in all the other quarters has averaged 2.5%.
The key to consumption is income. Wages are an important part of income. More people are earning a little bit more per hour. This can be expected to continue to underpin consumption on a trend basis. The recovery of the oil patch should support business investment. Over the past year, exports have grown four times faster than the growth of the overall economy. Despite USD's past rally, the trade deficit has not deteriorated and remains near its 12- and 24-month levels.
Investors may have gotten ahead of themselves in anticipating that President Trump's economic agenda of deregulation, tax reform and infrastructure spending would boost growth. The legislative agenda, as opposed to executive orders, is proving more difficult than many assumed, given the Republican majorities. On the other hand, as noted by the Fed's Vice Chairman Fischer earlier this week, and concurring with the IMF, the global economy is in somewhat better shape.
We argue that Fed policy has entered a new phase. It is more confident in the resilience of the economy. It will bring a new tool to bear in the normalization process later this year or early next year: the balance sheet. Meanwhile, the BoJ's Kuroda has confirmed what our contacts in Japan had hinted. Asset purchases in Japan will continue for "some time."
We suspect the next move from the ECB (next week) may be to tweak the securities-lending program, which may help increase the ability of the ECB to continue is asset purchases. Core inflation is stuck in a trough — 0.6% after bottoming in 2015 at 0.5%) — despite various unorthodox policies. By the time the ECB starts raising its negative 40 bp deposit rate, the Fed may have hiked rates 1-2 more times. The Fed may begin reducing its balance sheet while the ECB and BoJ expand theirs.
The political situation is admittedly very fluid. A trade war, perhaps precipitated by the border adjustment tax (BAT), or a currency war, spurred by attempts by President Trump to talk the dollar down, could diminish the role of divergence as a driver of the Obama-Trump dollar rally. We don't think we're there yet. The odds do not seem to favor Senate approval of BAT ,and Treasury Secretary Mnuchin has been quick to do damage control on Trump's dollar comments.