Originally published by AxiTrader
The US dollar recently made it's low on the 88.30/60 region in US Dollar Index terms. That was an important technical support level which enabled it - when translated to actual levels, support and resistance in euro, yen, Aussie, gold and so on - to start to build a base from which there was a reasonable chance it could find support and rally.
That was before Friday's stronger than expected US non-farm payrolls and wages growth data.
So, as the US dollar finds it feet it's worth thinking about why it fell, and what its prospects are going forward.
What have been the main drivers behind a weaker US dollar over the last year or so (e.g. fiscal/monetary policy vs rhetoric)?
The key driver of US dollar weakness has been the reality that US economic strength was assimilated early in 2017 via the “Trump trade” but even in March and April of that year global investors were wary citing “long dollars’ as the most crowded trade on the planet.
So when European, and global growth, lifted in a sustained and unexpected manner around the same time, and when Emmanuel Macron’s French Presidential victory ended the existential threat to the Euro project and thus the euro itself a massive rebalancing had to be undertaken as traders and investors recalibrated their expectations and portfolio allocations.
EUR/USD and the EU 2 year forward forward rate
It was this surprise, and the expectation that synchronised growth would drive central bank policy divergence, which then combined with trade and investment flows to drive euro buying and US dollar selling.
Lately, the past 6 or 7 weeks, it’s been the kind of one way bet where the US dollar has fallen heavily because traders are only focussing on euro positives. Ignoring any negatives and ignoring the obvious US dollar positives that set up a potential rebound either very soon or perhaps in Q2 2018.
Friday's data, and comments by Fed presidents Williams and Kaplan, along with comments from former chair Yellen have helped refocus expectations on policy divergence - or at least its potential.
How much weaker would the US be willing to let the dollar go? What’s the impact on US corporate competitiveness?
Given the Treasury’s funding task for the year, and years, ahead there is a balance the Administration has to seek between its mercantilist tendencies which – as Treasury Secretary Mnuchin said last week – give US business and the economy a competitive advantage from a weaker US dollar and he reality that an uncontrolled slide in the dollar could undermine global appetite for US debt.
So my sense is we are within 2-3% of the level the US Treasury would be comfortable with - or, to put it another way, 2-3% where they would become uncomfortable given the funding task. Indeed a move below 86.00/50 in DXY terms would breach a trendline from the 2014 low which could precipitate a wholesale capitulation of the dollar back to those lows near, or below, 80.
The other side of the coin, or exchange rate, of course is that the Europeans and Chinese – among others – would likely object to a sharp appreciation in their own currencies and the impact that would havce on their own businesses and economy. That reinforces my belief there is little tolerance in the official sector for much futher US dollar weakness
Are US trade partners reluctant to respond in kind (e.g. Europe, Japan, Korea) for fear of being targeted by US trade sanctions or tariffs?
No one wants a currency war.
The great strength of this post-Lehman collapse world was the establishment of the G20 and the fact that governments and central banks across the globe worked together for the global good.
That forestalled the beggar-thy-neighbor policies which intensified the Great Depression. The result is that it may have taken close to 10 years but we have a genuine and – apparently – self-sustaining economic recovery.
So we can rule out a currency war and expect subtle pushback from the EU, Japan, the UK, China and other nations via authorities like central bankers to the weaker US dollar.
We are already seeing that from the BoE, BoJ, and ECB.
Has this pushback been responsible for the US dollar's stabilisation
Narratives are important.
But while US treasury secretary Mnuchin's comments on the benefits of a weaker dollar reinforced US dollar selling in forex markets they also provided the kind of pessimistic crescendo necessary to see an asset stabilise at least - and often turn.
But the combination of BoE governor Carney's comment that he welcomed President Trump's clarification about the strength of the US dollar along with comments from ECB governing council members an appreciating exchange rate and forex volatility could tighten policy - not to mention the BoJ's increased JGB purchases last week to keep its bonds lower - has worked to change the narrative around US dollar weakness.
The question is though whether it is a sustainable turn in the narrative or simply hiatus before further selling.
So, what's next for the US dollar?
Friday saw the release of a very solid US non-farm payrolls which showed a solid rise of 200,000 jobs. That coupled with another solid 0.3% increase in average hourly earnings which took the yoy rate to 2.9% - from 2.6% - and the 4.1% unemployment rate contributed to the growing sense that the US economy really is doing well right now and that the added stimulus from the tax cuts – and the trickle down we are seeing from that – will see it continue to print solid growth numbers.
And it suggests the Fed is going to be more aggressive and inflation potentially higher than currently priced by forex markets.
On that front both Robert Kaplan of the Dallas Fed and John Williams from San Francisco were upbeat on the outlook for growth with Kaplan in particular saying he sees rising inflation pressures. Indeed Kaplan said he is more confident in three rates hikes but I thought Williams comment on bonds was telling. Williams said the bond market’s move was a “delayed reaction” to growth noting, “some of this adjustment seems to be a realization the economy’s doing really well, and obviously with the tax cuts that’s going to add further stimulus in the next years, and if anything the inflation data are heading in the right way”.
Tellingly in a comment which gives me a sense of the bond market in 1994 he said, “Markets sometimes take a while to get going and then they move more quickly”. That, of course, is an axiom that’s as true in any endeavour of life as it is in markets. Once things reach a tipping point they more often than not accelerate very quickly. And Williams, and of course me, thinks bonds have tipped.
And while recently it's been a global bond market rout there is room for divergence given the US looks to be in a different part of the growth/inflation cycle and thus the Fed's response will need to be very different to the ECB's
So central bank comments, and the data, have been responsible for a change in the narrative for the US dollar. That's seen the Aussie, kiwi, yen and many other currencies fall.
But what about the euro?
It is my strong contention that the ECB will end QE this year, even blind Freddy can see there is no need for emergency measures anymore.
But, they will be in no rush to tighten while their inflation performance continues to undershoot. Of course high oil prices and any success/leakage from IG Metalls 6% wage campaign can change that paradigm. But behaviourally the reason I think we hear so much from the hawks in vocal public disquiet about QE is because they are losing the battle at the board table. That’s something the Algo’s don’t get.
And the price action does not yet reflect.
So it is too early to say for certain that the US dollar has turned against the euro. Or that the moves against the Aussie and other pairs will be sustained.
Looking technically then for a guide we can say that EUR/USD has stopped making new highs which is the first sign of stalled momentum.
My analytical framework suggests euro needs a pullback. And further that the Fed/ECB divergence trade could make this a decent pullback. My trading self, my system too, is more circumspect.
A break below Thursday low at 1.2384 would be the first sign of a turn. But a move below my fast moving average at 1.2340 and last week’s low at 1.2334 would really change the game.
Here’s the chart.
Have a great day's trading.