Dollar View: Discipline or Stubbornness

The US dollar is sitting near multi-month lows against the major European
currencies and the dollar bloc. 
 
Where does this leave our strategic view of the third significant dollar rally
since the collapse of Bretton Woods?

The dollar bear market ended in 2007-2008 when extremes were made, with
the euro trading above $1.60 (2008), and sterling
above $2.11 (2007). 
The US dollar fell to nearly CAD0.90.  The
yen is a notable exception. It did not put it a top until 2011.  That is also
when the real broad trade weighted dollar bottomed as well.  

We anticipated a secular dollar recovery.  My book, Making Sense of the Dollar (Bloomberg, 2009)
argued against many of the “myths” that were used to justify and explain
the dollar’s decade-long decline, like it was losing it reserve status, or that
is chronic current account deficit was undermining its reserve status, or that
the Chinese yuan was going to replace the greenback.
  

The first dollar rally after the demise of the Bretton Woods system was fueled by the tightening of monetary policy
under Volcker and the expansionary fiscal policy associated with Reagan.

After intervention (Plaza Agreement, 1985) had arrested
the dollar’s rally, it entered the decade-long
bear market. 

The second dollar rally was associated
with the tech bubble in the second half of the 1990s.
  The groundwork
was the Fed tightening in 1994 and the abandonment of the occasional practice
of US Treasury Secretaries (like Baker and Bensten) of using the dollar as a
weapon to force concessions from US allies.  In October 2000, at the
behest of the ECB, there was coordinated intervention to stop the newly-born
euro from falling further.  This
meant capping the dollar.  It went through another multi-year bear
market.  

Early on, we identified the divergence of monetary policy, broadly
understood, as the driver of the third dollar rally. 
  While the
dollar bear market may have ended in 2007-2008, the bull market arguably did
not begin until the middle of 2014, and the Fed’s first hike was not delivered until the end of
2015.  

Our assessment that the third significant dollar bull market is still
intact rests on both fundamental and technical judgments

First, peak divergence is not yet at hand.  Specifically, we expect the Fed’s balance sheet to shrink by $30
bln in Q4, $60 bln in Q1 18 and $90 bln in Q2 18 for $180 bln reduction by the
middle of next year.  During this time we expect the ECB’s balance sheet
to expand by 300 bln euros (August through December) and by 180 bln euros in H1
18, for a total of another 480 bln euros.  

By the middle of next year, we suspect the Federal Reserve will hike
rates 2-3 times, while the ECB leaves its deposit rate at minus 40 bp
 
Interpolating from the OIS suggests the market is not convinced that the ECB
will move on rates until Q4 18.  

The second reason we are reluctant to abandon
our bullish dollar outlook is the price action itself. 
After a large
move, it is not unusual to see a counter-trend move.  The question is how
big of a counter-trend move before we say a new trend has begun.  
People who study price action have come up with a few rules of thumb.  We
use the Fibonacci relationships (especially, 38.2%, 50% and 61.8%) to measure retracements.  Other technical schools use similar but different retracements e.g., 25%, 33% 50%, 66% and 75%).  

Although the dollar’s pullback this year is more than we expected, regarding retracements, it is still quite
modest.
  For example, using the euro peak of almost $1.40 in May 2014
and the low set at the start of this year near $1.0340, the single currency has
almost met the 38.2% retracement at $1.1735.  The 50% retracement is found near $1.2170.   Sterling is nowhere close, but it has retraced 38.2% of the
decline from the $1.50 high seen in June 2015 (which is found near $1.3055).  The 38.2% retracement of the slide
from nearly $1.72 seen in July 2014 is almost $1.39.  

The yen, as often is the case,
marches to a beat of the slightly
different drummer.  The dollar recorded a low near JPY99 in June 2016.
 
It rallied to JPY118.65 by the middle of last December.  The greenback’s
low for the year was set in April near
JPY108, which is a little beyond a 50% retracement.  Last year’s low was
just beyond the 50% retracement of the entire Abenomics-sparked yen depreciation.
 

The Dollar Index retraced 38.2% of its rally from the 2014 low at 
94.30.
  It made a low yesterday of 93.64 but finished the North
American session back above 94.00.  It ran into offers today at it
approached 94.30.  The 50% retracement is near 91.35. 

We suspect the market sentiment has swung too far in Europe’s direction,
having rebuffed the challenge by the populist-nationalists.
  The eurozone continues to grow above trend, but the
momentum appears to be stabilizing.    
Macron’s election in France spurred several months of good feeling, but the
honeymoon is over.  Macron’s program of labor market flexibility, spending
cuts and tax cuts for the wealthy will spur a push back, which is what
prevented Macron’s predecessors from succeeding with their reform agenda. 
The top French general resigned over budget cuts, and Macron appears to have
ruffled feathers by taking credit for developments in Libya that were initiated
by Italy.    

Similarly, we are concerned that investors may be too negative the US.
  Market positioning, which had favored the dollar at the end of next
year, now is heavily biased toward short dollar positions.  Neither the
ISM, the Leading Economic Indicators, nor weekly jobless claims point to an
imminent recession in the US.   It is true that political uncertainty
and the unconventional US administration weighs on sentiment.  However, ultimately, we think monetary policy and the
broader economy are more important.
  It may simply require a greater
interest rate premium to offset or compensate for this risk.  

In conclusion, we identified the main economic driver of the dollar bull
market as divergence, and we see it still being intact
.  The dollar
has depreciated, but it has barely met
some minimum technical retracements that are common corrections in bull
markets.  If these considerations change, we are prepared to reassess our
outlook, but until they do, it seems premature to abandon our call.  













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