The Federal Reserve’s real broad trade-weighted dollar fell for the first
three months of 2017, and the greenback’s heavy tone this month has raised
questions about the state of the bull market. Despite
this recent weakness, we think the bull market is intact and that the advance
will resume.
In the February through April last year, the real broad trade-weighted
measure of the dollar fell. Many investors doubted the bull market
was intact. The greenback proceeded to rally seven of the following eight
months. In 2015, this measure of the dollar fell in three of the 12 months, and two were back-to-back (April and
May). In 2014, there was a three-month losing streak (March-May).
It then appreciated in six of the following seven months. Of
course, history does not repeat itself.
Graphic here depicts the real broad trade-weighted
index(white line) and the euro (yellow line). The chart goes back to
1990. I am uncomfortable showing two time series on two scales on a single chart, as this practice seems
abused on Wall Street. However, for given this, the two track each
other pretty closely and for good fundamental reasons. Europe is a
significant US trade partner and shares
many of the same drivers of headline inflation, like energy.
To assess the dollar’s bull market in a disciplined fashion, and to avoid
getting caught up in short-run disruptions, we come back to our
assessment of the driver. We argue that first significant dollar rally
post-Bretton Woods (the Reagan dollar rally) was
driven by the policy mix of loose fiscal policy and tight monetary
policy (under Volcker). The second dollar
rally (Clinton dollar rally) was driven by the carving out of the internet
(leading to the tech bubble)/ We note that the Fed began raising rates in
1994 and the dollar’s bull market began in the spring of
1995.
We see the current dollar rally (Obama-Trump), the third since Bretton
Woods. What allowed us to anticipate it was our understanding of the driver: Divergence of monetary policy
broadly understood. The Federal Reserve responded early and aggressively
to the financial crisis. It began its unorthodox policies in 2009,
several years before the Bank of Japan and the ECB began their efforts. This, coupled with
the flexibility of the US economy, produced results earlier, allowing
the Fed to exit and begin normalizing policy before most of the rest of the
world.
The question of the state of the dollar bull market is a question, in our
mind, of whether divergence remains intact. We think it
does. Softer Q1 GDP, with the pullback in consumption, we
judge as a temporary soft patch.
Growth in the January-March period has been
typically soft beginning in 2010. From 2010 through 2016, growth in Q1
has averaged 1.1%. Growth in all the other quarters has averaged
2.5%.
The key to consumption is income. Wages are an important part
of income. More people are working earning a little bit more per
hour. This can be expected to
continue to underpin consumption on a trend basis. The recovery of the
oil patch should support business investment. Over the past year, exports have grown four times faster than the growth of the overall
economy. Despite the past dollar rally, the trade deficit has
not deteriorated and remains near its 12- and 24-months.
Investors may have gotten ahead of themselves in anticipating that
President Trump’s economic agenda of deregulation, tax reform, and infrastructure spending would boost growth.
The legislative agenda, as opposed to executive orders, is proving more
difficult than many assumed given the Republican majorities. On the other
hand, as noted by the Fed’s Vice Chairman Fischer earlier this week, and
concurring with the IMF, the global economy is in somewhat better
shape.
We argue that Fed policy has entered a new phase. It is more confident in the resilience of the economy.
It will bring a new tool to bear in the normalization process later this year
or early next year: the balance sheet. Meanwhile, the BOJ’s Kuroda
has confirmed what our contacts in Japan had hinted. Asset purchases in
Japan will continue for “some time.”
We suspect the next move from the ECB (next week) may be to tweak the
securities lending program which may help increase the ability of the ECB to
continue is asset purchases. The fact that core inflation is still stuck in the trough (0.6% after bottoming in 2015 at 0.5%) despite the various
unorthodox policies. By the time the ECB being raising their negative
40 bp deposit rate the Fed may have hiked rates 1-2 more times. The Fed
may begin reducing its balance sheet while the ECB and BOJ expand
theirs.
The political situation is admittedly very fluid. A trade war,
perhaps precipitated by the border adjustment tax (BAT), or a currency war,
spurred by attempts by President Trump to talk the dollar down, could diminish
the role of divergence as a driver of the Obama-Trump dollar rally. We
don’t think we are there yet. The odds do not seem to favor
Senate approval of BAT, and Treasury
Secretary Mnuchin has been quick to do damage control of Trump’s comments about
the dollar.