U.S. Dollar Decline Looking Over-Extended

Financial Times – Dollar sinks on failure of healthcare reform
US currency hits 10-month low as hopes fade for Trump economic stimulus
The dollar has been a barometer of prospects for the Trump administration’s efforts to enact pro-growth policies of tax cuts and fiscal stimulus. As the administration has become bogged down in the past six months handling healthcare reform and dealing with the Russia scandal, the reserve currency has steadily retreated. Lacklustre economic data, notably a weaker tone for inflation and retail sales for June, have prompted the bond market to reduce the likelihood of further interest rate increases from the US Federal Reserve.
Wall Street Journal – Why a Weaker Dollar Is a Source of Market Strength
The dollar is down. But that is good news for markets
The WSJ Dollar Index has now unwound the boost it got from the election of Donald Trump in November, and is down about 6.5% this year. The greenback’s key counterpart, the euro, is up close to 10% in 2017. Early Tuesday, the euro rose above $1.15 for the first time since May 2016, reaching the top of the range it has been in since the start of 2015 under the influence of monetary-policy divergence between Europe and the U.S. The transformation in the dollar and euro’s relative fortunes in 2017 has been remarkable. The focus at the start of the year was on the U.S. Federal Reserve and its efforts to raise interest rates; now the European Central Bank has stolen the spotlight as it tacks gently away from ultraloose policy settings.
Wall Street Journal – Dollar Doldrums Mean Easier Money
The Goldman Sachs Financial Conditions Index, a widely-watched gauge, was at its lowest since late 2014 this week. The lower the index, the looser the flow of money, based on factors like bond yields and the value of the dollar against its peers. Much of that is the result of a falling greenback. The WSJ Dollar Index, a measure of the U.S. currency against 16 others, is down 6.5% since the end of last year. The index was down another 0.6% Tuesday morning at its lowest level since October, before the presidential election spurred a big surge in the dollar.

Summary

Expectations for sustained weakening by the U.S. dollar seem to be fashionable lately. And there are many reasons why this could be the case. We discussed some of them yesterday as they related to potential tailwinds for emerging markets. But there are signs the dollar’s latest decline is over-extended, short-term outlook aside. The potential for sustained dollar weakness, which would mean persistently loose financial conditions, may complicate the Fed’s plans.

Comment

Despite agreeing that medium-to-long-term influences point toward persistent U.S. dollar weakness, we see two signs that the short-term outlook is brightening. The first is a simple momentum indicator we use to highlight overbought and oversold conditions. The chart below shows oversold conditions (indicator below -0.5) beginning to appear.

The second is that our 20-day forecast model is beginning to lean bullish for the dollar. The model estimates the probability that the Bloomberg U.S. Dollar Index will close higher in 20 days. The recent dollar selloff has seen this probability climb to 76.8%. You can read more about the model here.

It’s important to note that the latest decline accelerated as the markets tried to gauge political consequences of a defeat to GOP-led health care reform. Deteriorating political risks would be well outside the scope of the model, which considers changes in changes in the yield curve, relative performance of global equities, global risk indices, economic data and gold. The volatile political environment in the U.S. is a risk fact for dollar weakness to continue or even worsen.

Setting aside the short-term outlook for a moment, the potential for persistent U.S. dollar weakness will complicate discussions within the FOMC as they progress toward balance sheet normalization and consider further rate hikes in 2017. We have discussed how financial conditions do not necessarily tighten as the Fed is raising interest rates. And we’ve also discussed how uncertainty and financial stability concerns tend to accompany tighter financial conditions. But the second Wall Street Journal story above illustrates another point.

The chart below from the Wall Street Journal story clearly shows just how influential the U.S. dollar weakness has been in driving financial conditions lower (looser). The potential for sustained dollar weakness means a potential medium-to-long-term bias for looser financial conditions. As we’ve mentioned before, New York Fed President William Dudley has promoted the Goldman Sachs Financial Conditions index within the Fed as a means to gauge policy effectiveness. We’ve noted that the influence of the stock market may be problematic if the Fed misses other signals like the yield curve. If the weaker dollar is clouding the signal in the index, the Fed risks tightening too quickly.

This is precisely the opposite challenge they faced as they marched toward the final tapering in late 2014 and the first rate hike in 2015. Both instances saw markets build a massive premium into the U.S. dollar as the Fed was the only central bank tightening policy. There is potential for this premium to be unwound as the Fed begins to slow its pace of tightening and other central banks converge on tighter policy stances. The Fed may be happy to see economic tailwinds from a weaker U.S dollar given recent weakness in economic data. But weighing these offsetting influences will make for complicated discussions and tricky communications in the months ahead.

Conclusion

Despite valid reasons to expect persistent U.S. dollar weakness, we see some signs that this latest decline is getting over-extended. Firming expectations for more dollar declines are driving positioning across many assets, especially emerging markets. A near-term correction isn’t likely to derail medium-to-longer-term dollar weakening. An eventual return to dollar weakness, or continued dollar weakness despite oversold conditions, will complicate the Fed’s discussions about further tightening this year.