Tuesday, October 7, 2014

All Hail the Mighty Greenback?

Sri Jegarajah of CNBC reports, 'Nuanced' Q4 dollar gains as monetary policy diverges:
The divergence in global monetary policy - as the Federal Reserve prepares for its first rate hike in mid-2015 while counterparts in Japan and Europe consider adding stimulus - will drive the U.S. dollar higher this quarter, a CNBC survey of currency strategists and traders shows.

The rise of the dollar index – a gauge of the greenback's value against a basket of six major currencies – has been virtually unassailable, racking up gains for a record 12 straight weeks – its longest winning streak since its 1971 free float under President Nixon.

"We expect a strategically strong dollar over an extended period measured in months and years," said David Kotok, chief investment officer at U.S. money manager Cumberland Advisors with $2.3 billion in assets under management. "Our central bank is at neutral and unlikely to revert to QE (quantitative easing) again. The rest of the world has not reached that stage."

Kotok is not alone. Eighty one percent of respondents expect the greenback to set new highs, while just under a fifth believes the rally will fade.

In a research report on September 30, Deutsche Bank flagged the dollar's ascent as a major headwind for the commodities complex and predicted that the move has further to go.

"A new long-term uptrend in the U.S. dollar is now firmly entrenched and will continue to pose risks to large parts of the commodities complex," Deutsche Bank strategists said in their Commodities Quarterly. "On our reckoning we are only half way through the current U.S. dollar cycle in duration and magnitude terms."

Fed policymakers last month indicated that they expect faster rate hikes next year and the year after. The central bank in its mid-September meeting pushed up its expected path of interest rate increases – the so-called Fed 'dots' forecast. That's likely to set the tone for further dollar gains, though yields on U.S. treasuries - on short and medium-dated notes - suggest the bond market remains unconvinced.

"For Q4 we believe U.S. economy remains on track which means market's rate expectations will move to align more closely with the Fed's 'dot' forecasts," said Vassili Serebriakov, currency strategist at Wells Fargo. "The USD should remain supported, and we see EUR/USD at 1.25 and USD/JPY at 112 by the end of Q4."

A bit stretched

Still, some argue the rally risks exhaustion towards year-end after such a blistering and historic run. The dollar index rose to a four-year peak at the start this quarter, boosted by upbeat U.S. jobs data on October 3.

"[The] dollar has scope for continued upside but the move is getting a bit stretched and may become more nuanced into the year-end," said Ilya Spivak, Currency Strategist at FXCM Live.

Nick Bennenbroek, head of currency strategy at Wells Fargo, said 'corrective weakness' was in store for the U.S. dollar: "While the Fed is moving closer to tightening, policy action is not imminent just yet. Against the backdrop of current market positioning, that provides some scope for the U.S. dollar to soften."

Meanwhile, dollar bears emphasize that the currency's headlong rush higher is at odds with economic fundamentals. "The strength in the U.S. dollar doesn't necessarily reflect underlying economic strength," said Gavin Wendt, Founding Director & Senior Resource Analyst at Sydney-based Mine Life Pty. "The market is being misled with respect to potential Fed interest rate increases - I can't see the Fed raising interest rates in mid-2015 as the economy won't support it."

The dollar index (DXY) hit a high of 86.74 on Friday - its strongest level since June 2010 - and rose 7.7 percent in the third quarter. That's its largest percentage increase since a 9.6 percent gain in the comparable period in 2008.
Gaurav Kashyap, head of futures at Alpari Middle East, shared his firm's views on currencies in the UAE National, US economy sways world currency markets:
The US dollar is on a roll. The currency’s gains last month took the US Dollar Index near four-year highs.

The Dollar Index, a measure of the greenback’s value against a basket of currencies including the euro, the yen and the pound, appreciated more than 3.8 per cent in a month, which all but solidified the bull trend for the dollar and primed it for an even stronger closing through the end of this year.

In its third consecutive month of gains, the Dollar Index is approaching levels last reached in 2010, and technically a move towards 88.64 will be next up for the currency. The dollar has been a big beneficiary of the one-way downwards move in the euro, which was further exacerbated last month, but the improved sentiment about the US economic situation continues to build momentum and this is converting into increased flows into dollar-long positions.

Amid a stellar US economic calendar last month filled with stronger-than-expected numbers, perhaps the key figure was the headline US nonfarm payroll report. The most recent data showed that 248,000 new jobs were added in September, well above expectations of 215,000.

The key takeaway from the report was the unemployment rate, which dropped to 5.9 per cent, below an expected 6.1 per cent and the lowest since July 2008. The improved figure caused large inflows into dollar-long positions (the Dollar Index gained more than 1.2 per cent on Friday) as the data further solidified the US recovery and increased bets that the Federal Reserve would look at increasing rates sooner rather than later.

Estimates have the Fed poised to increase US interest rates in July next year, but the US data docket showing signs of improvement leads to increased speculation of a rate hike sooner than expected – and this expected interest rate differential leads to an increased demand for the currency with the higher interest rate, in this case the dollar. With the European Central Bank in the midst of aggressively cutting rates, the euro-dollar pair is susceptible to further downsides through the medium term.

The euro’s torrid run continued through last month, with the common currency slipping 3.85 per cent against the dollar and 1.6 per cent against the British pound. The euro-dollar conclusively took out our target support at 1.28 to close just above 1.25 levels.

Technically, we predict the euro-dollar testing the 200 Month Average, which sits at 1.2214 in the month ahead, and with the current condition of the European data docket we fully expect this target to materialise.

The ECB president, Mario Draghi, last month slashed rates across the board. The main refinancing rate was cut to 0.05 per cent from a previous 0.15 per cent, the deposit facility rate was cut to minus 0.20 per cent from minus 0.10 per cent and the marginal lending facility rate was cut to 0.3 per cent from 0.4 per cent.

Although the ECB could not cut rates any further at its latest meeting last Thursday, Mr Draghi hinted at further asset purchases in the region of €1 trillion. The potential for such an increase in the ECB’s balance sheet will no doubt continue to pile the pressure on the euro, and with the data coming out of Europe showing no signs of improvement, it is not a matter of if but when Mr Draghi will pull the trigger.

The fundamental drag of upcoming ECB action will no doubt test 1.22 in the euro-dollar cross, and looking ahead to the closing months of the year this could open the door to a break of 1.20 levels. We still expect the cross to hold above 1.18 for the rest of the year.

Along with the euro, a stronger dollar will also lead to further downsides in the pound, the Australian dollar and gold in the month ahead.

The Scottish vote was a make or break for British pound forecasts, and although the No vote made the pound-dollar rally initially to 1.65 levels, a weaker second half of last month caused the cross to close below 1.60 for the first time in 11 months. The Australian dollar moved to its lowest level this year, and deteriorating sentiment from China will continue to weigh down Aussie-US dollar forecasts. The Australian dollar gave up more than 6.2 per cent against the greenback last month and we expect the weakness to continue in the month ahead with a test of 0.83 on tap.

And finally, gold is consolidating around a key support level of US$1,180 an ounce. Despite the recent bear trend in the precious metal, we expect these levels to hold in the month ahead while stabilising in the current range to close out the year.
I'm not going to get all technical on you but from a fundamental perspective the strength in the USD doesn't surprise me. The U.S. economy is recovering nicely while the rest of the world is languishing, especially in the euro zone where German factory orders plunged the most since 2009, underlining the risk of a slowdown in Europe’s largest economy.

I've been warning my readers of the euro deflation crisis and having just visited the epicenter of this crisis, I came away convinced that the euro will fall further. In fact, I wouldn't be surprised if it goes to parity or even below parity over the next 12 months. There will be countertrend rallies in the euro but investors should short any strength.

What is my thinking? First and foremost, the European Central Bank (ECB) is falling way behind the deflation curve. Forgive the pun, but as long as Draghi keeps dragging the inevitable, meaning massive quantitative easing, the market will continue pounding the euro. The fall in the euro will help boost exports and more importantly, import prices, fighting the scourge of deflation.

Once the ECB starts ramping up its quantitative easing (QE), there will be a relief rally in the euro and you will see gold prices rebound solidly as inflation expectations perk up. This is counterintuitive because typically more QE means more printing which is bearish for a currency -- and longer term it will weigh on the euro -- however over the short-run, expect some relief rally.

But the problem is this. You can make a solid case that the ECB has fallen so far behind the deflation curve that no matter what it does, it will be too little too late to stave off the disastrous deflation headwinds threatening the euro zone and global economy.

Now, if you ask me, there is another reason why the USD is rallying strongly versus all other currencies and it has little to do with Fed rate hikes that might come sooner than the market anticipates. When global investors are worried about deflation and another crisis erupting, they seek refuge in good old U.S. bonds. This has the perverse effect of boosting the greenback (USD) and lowering bond yields, which is why I'm not in the camp that warns the bond market is more fragile than you think.

What does the strong USD mean for the U.S. economy? It means oil and import prices will drop and exports will get hurt. Ironically, lower oil and import prices will reinforce deflationary headwinds, which isn't exactly what the Fed wants. But the stronger USD might also give the Fed room to push back its anticipated rate hikes. Why? Because the rise in the USD tightens up financial conditions in the U.S. economy, acting as a rate increase.

In terms of stocks, the surging greenback may be a triple whammy for U.S. earnings. Multinationals which as a group derive almost half of their revenue from international markets, will see a hit on their earnings, especially if they didn't hedge accordingly. But you should see small caps (IWM), which have been beaten down hard in September and thus far in October, rally as they're more exposed to the domestic market.

Despite the October selloff, I'm not worried of another stock market crash. I maintain that the real risk in stocks remains a melt-up, not a meltdown, but you have to pick your spots carefully or risk getting slaughtered (look at coal, gold, commodity stocks that were obliterated in 2014). This is why a lot of active managers underperforming this market will continue to do so as we head into year-end. There are a lot of things that could derail this endless rally but there is still plenty of liquidity to drive all risk assets much, much higher.

Having said this, we are at an important crossroad here. The euro deflation crisis is threatening the global economy. If the ECB doesn't act fast, it will get worse, and likely spill over to the rest of the world. Then you will see more quantitative easing from all central banks as they try (in vain) to fight the coming deflation spiral.

Once again, please take the time to listen to this excellent interview with economist Richard Duncan, author of The New Depression. I saw this in Greece and highly recommend you take the time to listen carefully to Duncan's comments. It cements my thinking that there will be more printing ahead, a major liquidity rally in risk assets, followed by a protracted period of debt deflation.

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