Our underlying constructive outlook for the US
dollar remains intact. It is broadly
based on the divergence between the US and most other major
economies. The US acted early and aggressively to counter the Great
Financial Crisis. Unorthodox policies, such as quantitative easing,
were adopted years before the ECB and BOJ. This has produced different outcomes. US economic growth may
not be impressive by pre-crisis standards, but it does not seem particularly fragile.
The Federal
Reserve may be normalizing monetary policy more gradually than we anticipated,
but the ECB and BOJ are more aggressive. Although there was a
scare around the UK referendum, the derivatives markets clearly show that the
next Fed move is a hike, not a cut.
Many observers expect the ECB to ease by changing from the capital key
to a debt market measure to guide its sovereign bond purchases. This would reduce the quality of assets being bought,
which some economists regard as more aggressive policy. Many also expect
that the ECB will announce in Q4 that it will extend its purchases, which have
a soft end-date of the end of Q1 17, after having been extended once
already.
The BOJ is expected to ease policy as early as
next week. It may be part of a larger fiscal-monetary initiative to
strengthen the economy and arrest falling prices. The Bank of
England gave as clear a signal as can be reasonably expected that it will ease
monetary policy next month. Australia and New Zealand may cut rates next
month as well.
At the same time, the US economy appears to
have accelerated in June, and that
momentum should carry into Q3. The service sector ISM was the best of
the year. Jobs recovered from May’s fluke. Manufacturing and
industrial output strengthen. Retail sales were stronger than expected,
and price pressures were slightly firmer.
The Dollar Index is not a good proxy for a
trade-weighted index. Two of the US largest trade partners, Mexico
and China, for example, are not included. However, for a rough and ready
proxy, the Dollar Index may be useful. After trading broadly sideways in
in H2 13 and H1 14, the Dollar Index rally from around 80 in mid-2014 to 100.50
by the end of Q1 15.
It has not made a new high since, and this
spurred speculation that the dollar’s rally is over, that the divergence meme
has been fully discounted. We
see it a bit differently. The broad
sideways movement in the Dollar Index since March 2105 has primarily a consolidative
phase, from which it will launch another leg higher.
After a big run-up,
it is not unusual to have a counter-trend move. Technicians look for retracements of the rally to determine
whether it is corrective or a reversal (start of a new trend). A common
minimum retracement is 38.2%. The Dollar Index flirted that retracement
objective (~92.55). It penetrated
it once (early May 2016), but never closed below it. This suggests that the uptrend is still intact,
and the sideways movement was corrective in nature.
Today the Dollar Index is trading at its
highest level since March. It is approaching a downtrend line drawn
off last December’s high and the highs from late-January and
early-February. Depending on how the line is
drawn, it comes in between 97.40 and 97.75. Also, the 97.20 area corresponds to a
retracement objective (61.8%) of the losses seen since last December’s high.
Technical indicators on the weekly bar charts, like the RSI and MACDs are
consistent with additional dollar gains.
While the 100.50 area, a little more than 3%
from current levels is the upper end of the 18-month range, we look for this to
give way in H2. Our target above there is 101.80, and a move through
there would likely coincide with the euro approaching parity.