US Economy’s Chill Leaves The Dollar Cold

  • EUR busts through psychological €1.1400 handle
  • Inflated EUR to hurt export-dominated Europe
  • Crude prices supported by production, not global growth
  • Fed rate hike being pushed into 2016

With widespread concern the U.S. economy’s cooling in the first quarter has less to do with winter and more to do with flagging consumerism, the greenback dipped to its lowest point in months against several currencies on Thursday. Notably, the common currency climbed to its highest peak against the U.S. dollar (€1.1423) since last February.

The speculative investor has being trying to pick a EUR top since the onslaught of the bund rout, and so far they have failed miserably. The single unit is down more than -5.5% against the dollar since the start of the year, but up almost +2% since the start of May. This morning, the dollar has managed to tumble to its lowest level in two months (€1.1423). What we have seen in markets over the past two weeks has been triggered mostly by fear and not by a change in the outlook for economic fundamentals. Combined with a lack of liquidity problem, some of the most popular trades are being stretched (short EURs, long USDs, short commodity currencies, etc.).

Inflation Expectations Have Not Changed

Since the middle of April, crude prices are up +45% from their one-year lows, with +60% of that rise due to a reduction in production and not growth expectations. Global first-quarter growth is projected to be +1.2%, the lowest in 25 years. Currently, the biggest global bond rout in two years is putting investors in a dangerous place. Technically, they are challenging the world’s most influential central banks’ low interest rate policies and quantitative easing (QE) measures. Sustainable higher energy prices, supported by growth, will lead to higher inflation expectations, but there is little to no change to inflation expectations in the past two weeks in either the U.S. or Europe. In fact, there are still many in both economies betting inflation will remain below 1%. Worldwide inflation expectations of +0.4% in the first quarter will be the lowest in two decades. The “big” dollar’s demise is inflating commodity prices.

Bond Yields Continue to Rise

Sovereign debt markets are usually considered relatively stable with intraday yields moving only a few hundredths of a percentage point a day. In less than three weeks, Germany’s 10-year bund yield has rallied +75 basis points from a record low yield of +0.05%, and U.S 10s have gone from +1.85% to +2.32%. The price move is equivalent to three rate hikes and then some. Receding deflation concerns, upcoming supply issues, and worries about trading liquidity have all been cited as reasons behind the recent bond selloff.

Despite debt markets having lost about $500 billion in value and yields having spiked, monetary policymakers are showing no signs of an imminent increase in the price of money. The European Central Bank (ECB) and the Bank of Japan are still conducting QE. The ECB only started its QE program last March, and President Mario Draghi’s monthly +€60 billion debt demand is expected to cap the upside for yields. QE is slated to continue until September 2016 as there are no reasons to end it sooner. Currently, higher yields are supporting the EUR, and a stronger EUR will only weigh on the export-driven companies in the eurozone, which does not support growth and does not justify rates being so high. There is an argument for a normalized rate curve, but European growth remains uneven and bumpy at best and shows no signs of being sustainable. For evidence, looks at the eurozone’s economic powerhouse Germany’s preliminary gross domestic product first-quarter number released yesterday. It was a disappointing +0.3% versus an expected +0.7%.

The Fed Looks for Clarity

The Fed has its problems, too. Fed officials want to raise rates, but the timing is crucial, as too soon could unwind all the good that would require them to backpedal. Fed Chair Janet Yellen and her fellow cohorts are trying to justify their next move on the back of the first quarter “transitory” blip. Yesterday’s U.S. retail sales number was a bust and a big disappointment to those who are banking on a second-quarter rebound in consumption. The drop in year-over-year energy prices (tax savings), higher savings, and a stronger labor market (+5.4% unemployment rate) has yet to convince the U.S. consumer to spend.

The Fed’s normalization rate time line is data dependent, but the latest batch of economic releases are very much mixed and are accompanied with quite a bit of market noise. This would suggest that recent asset price moves are not wholly fundamentally driven. The stretch positions taken of late are led mostly by fear and liquidity constraints, whether it’s in fixed income, commodities, or forex asset classes. The Fed’s data dependency motive gives it little choice but to wait for such clarity. Hence why U.S. fixed income is looking further out their curve for the first rate hikes. Some dealers are leaning toward September, but current data would suggest that the Fed has time on its side. This is allowing others to push back Fed rate hike expectations into next year.

Owning USD has been the only true trade of note since the inception of rate divergence talk from the Fed. The problem is that fundamentally, the U.S. economy is falling short of expectations and is not backing up these trades. With this in mind, the market still needs to pare some of those positions. The highly concentrated “long” dollar trade is taking it on the chin with the change in timing, and it’s why the dollar remains vulnerable to the downside in the near term. Its weakness will be exaggerated by position adjustment. So investors should be expecting more blood, more position squeezes, and prices moves that do not make any economic or monetary sense. The Reserve Bank of Australia, the Reserve Bank of New Zealand, and the Bank of Canada, for instance, do not support stronger commodity currencies, but the dollar’s partial unwind has those currencies trading at multi-month highs.

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Dean Popplewell

Dean Popplewell

Vice-President of Market Analysis at MarketPulse
Dean Popplewell has nearly two decades of experience trading currencies and fixed income instruments. He has a deep understanding of market fundamentals and the impact of global events on capital markets. He is respected among professional traders for his skilled analysis and career history as global head of trading for firms such as Scotia Capital and BMO Nesbitt Burns. Since joining OANDA in 2006, Dean has played an instrumental role in driving awareness of the forex market as an emerging asset class for retail investors, as well as providing expert counsel to a number of internal teams on how to best serve clients and industry stakeholders.
Dean Popplewell