The U.S. gross domestic product report for the second quarter of 2017 confirmed that economic growth accelerated to a 2.6 percent annualized rate from the first quarter’s sluggish 1.2 percent pace. That should reassure equity investors, but dollar bulls face a number of significant headwinds, including weak inflation, bearish trading technicals and now potential for U.S. fiscal policy disappointment.
It’s been a tough year for the greenback, which has already fallen some 9 percent as measured by the Bloomberg Dollar Spot Index. Add to that the dour outlook issued by the International Monetary Fund, which earlier this week lowered its forecasts for U.S. GDP growth in 2017 to 2.1 percent from 2.3 percent, and cut its outlook for 2018 to 2.1 percent from 2.5 percent.
Five year / weekly chart: The US dollar index is testing a major support area of 93. Below that is 84-85. Then 79 comes in to view. Break below 93 could be major. Index is very oversold now, so not surprised to see a pop, and then drop. Momentum could be big on the way down.
Further, in my technical view USD had too much trouble getting much above 100. There’s a solid ceiling in place, while support is breaking down. Lots of potential momentum to the downside given the catalysts: dysfunctional gov’t, enormous debt burden, no signs of Fed effectively tightening or reducing balance sheet in meaningful way, and huge amounts of capital seeking higher returns will likely go to EM and EU.
As the dollar surges past 97, toward 100, the rest of the market seems to be catching on that this is a risk off signal. Just about every asset class is selling off today as a result. There’s no single catalyst for the stronger dollar. More a myriad of micro-catalysts:
- The assumption that the EU, UK, Japan and others will continue QE and ZIRP/NIRP as the US Fed raises rates.
- The notion that the US Fed will raise rates at a faster pace (than they have in the last 3 years of jawboning about it).
- The structural economic problems in other economies (making ours seem like the least bad of the bunch).
- Weakness in demand for assets in Japan and Europe.
- Brexit and the follow-on economic impact on UK.
With all of that in mind, I believe that the current leg of the US dollar rally is becoming problematic for the goals of the US Federal Reserve. Indeed, a strengthening dollar on top of rising US Treasury yields is in a way a de facto tightening. Liquidity tightens and lending/margin speculation decreases.
Should the rally strengthen I believe it will create a significant downside catalyst for a multitude of other asset classes. And there is some small chance that it could spiral in to a deflationary headwind should the situation grow out of the control. My opinion is that the dollar strength could be utilized as an entry point in to beaten up asset classes, especially commodities and emerging markets.
Let’s watch carefully and see where the market takes us from here.
The British pound keeps reminding me that once a reserve currency loses the confidence of its participants, volatility becomes a big problem.
Crashing, as it had post-Brexit and most recently during an HFT-triggered 2 minute flash implosion, shows that even the most liquid markets can become bidless.
This is, in a nutshell, why diversification of investments, including across different asset classes and base currencies, is critical.
The Brazilian Real was walloped and the dollar was clearly a standout winner. Gold’s relative underperformance shows against US dollars that the US dollar is still seen as a safe haven currency.
Until that changes gold will underperform as measured by US dollars. I think we’re closer a that point in time when we see positive price action then we were a year ago, but I can’t say for certain if the markets will agree until stocks move in to a bear market.
As seen in the start of 2016, when stocks were out of favor, gold caught a bid and moved higher each day stocks were sold off. Now that stocks are catching a bid, gold is selling off.
Whether or not 2016 is the year that stocks enter a bear market remains in question. I am inclined to think that we have only seen a prelude for the downside in stocks that could occur this year.
Storms are brewing. The wind will carry them from the east to the west. Be careful out there.
Thursday will be another difficult day in stocks and risky credit markets. The dollar is no longer being seen as much of a safe haven. Gold is catching a bid, but for how long?
As we approach extremes in bearish sentiment, the number of gold ounces promised per contract (on the Comex at least), relative strength and the dollar rallies on the promise of a tightening cycle — I think it’s important to take a moment and reflect.
Interest rates make a bad situation worse for debtors
The US government currently spends over 6% (about $250 billion per year) of its budget on interest alone. If interest rates were to normalize this figure would swell significantly. So the idea of a tightening cycle being a possibility without a significant (and deflationary) reduction in government spending is unlikely. Even if spending were to be decreased, it would not be in time to reduce the deficit or debt burden.
Further, liabilities in the private sector are exploding. Student loans, car loans, credit card debt, mortgages and debt-driven share buybacks are all at unprecedented levels. This is further evidence that the system at large is far too debt-dependent to move to a higher rate structure without a significant rise in insolvencies.
Leverage and volatility don’t mix well
Lest we forget the interest rate complex at large. The biggest swath of derivatives in the world, hundreds of trillions of dollars of leveraged OTC instruments, are tied directly to it. To give you an idea of its scale, the amount of interest derivative products alone dwarf the global GDP by nearly 7 fold.
Large moves in short periods of time render leveraged trades insolvent due to the trade turning against them. If one is borrowing $9 for every $1 they put in to a trade, then if the trade goes against them by 10% they are wiped out. More than 10% and they owe more than the $1 they put down.
This is precisely the risk present in the world of derivatives. The only difference is the leverage is much, much higher than 10 to 1.
Another problem is that in a tightening environment that’s unilaterally led by the US central bank (when other central banks do not follow), deflationary shock waves may proliferate throughout the global financial system and wreak havoc on interest rate derivatives markets, emerging equity and bond markets, US corporate debt and ultimately global financial markets as a whole.
Sensitive markets showing stress
Given the level of medicine applied, one would expect the patient (the global economy) to have either rebounded or died of an overdose. Neither has happened, but markets are essentially in the eye of the storm. The troubles past are gathering speed again at a remarkable pace behind the scenes.
Consequences are continuing to climb
This time around it is not just the financial system at risk, it is many governments of the world and many of their respective central banks that risk insolvency. We are witnessing the biggest bubble that has ever been blown in history.
No wonder there is so much effort in preserving such a bubble. The result of its end is a mind blowing problem. And that’s precisely why the rate normalization cannot happen. We may see a push higher by 25-50 basis points.
Policy road fork ahead
Such a hike, however, will in all likelihood pale in comparison to how the Fed manages its maturing balance sheet of bonds. A new round of QE-like activity will likely emerge as those funds that mature are put to use to purchase longer dated bonds to re-stimulate debt markets in a variant of operation twist.
As equity markets finalize what appears to be their ultimate topping formation, I assume that we will witness another sharp move downward. The Federal Reserve appears to be more sensitive to the gyrations of financial markets than the economy at large. As a result it will likely pause and possibly even reverse in to this new variant of operation twist.
Ultimately this is bullish for gold
I believe we will have already formed the bottom in precious metals and begin to see a resurgence in prices once the stock market has topped and the Federal Reserve is no longer willing to tighten. Whether the gold price tests the $1,000 level is still on the table, but I don’t see much further downside from here based on these assumptions.
An unusually strong jobs report, which saw seniors take the lion’s share of the new jobs, caused an enormous continuation of the recent US dollar rally. The move knocked commodities down, causing the entire complex to shudder.
This strength is predicated on a forthcoming Federal Reserve rate hike in December. The same rate hike that has been put off for almost a year by policy makers that talk a lot, but do very little.
If the past is any indication of how this current trend will play out, most of the strength in US dollar rallies (and conversely, commodity weakness) happen before the first rate hike.
If that’s true, we may be through the worst of the US dollar rally — assuming the Fed actually hikes in December. If not, or if the dollar continues its ferocious path higher, there will be significant headwinds for US corporate multinational earnings as well as the entire commodity complex.
A little up, a little down. No real certainty to go around.
Things are going to be quiet until the big decision day. Economists and market mavens can’t decide whether the Fed will engage in more QE, keep rates as is or hike (and if so by how much).
This means the Fed is doing part of their job well. Forecasting everything ahead of time would leave market participants tempted to front run events like interest rate hikes with their bets.
On the other hand, the lack of certainty also shows that the recent market volatility may have the Federal Reserve Board divided as to how tight financial conditions may be with an interest rate raising cycle coming on to the horizon.
There’s going to be a lot of volatility when the decision comes out. Probably best to expect large price moves with air pockets in the volume of trade — meaning a whipsaw effect up and/or down as the news breaks.
It’s generally a good day to sit on the sidelines and watch the markets rather than participate.
With all of the fervor over the US dollar index rallying close to 100, a reality check is in order. According to financial media reports the Euro is collapsing, gold is a barbarous relic that’s lust its luster, oil is falling and the commodity complex itself is imploding. Readers of this blog may remember that on November 1st of 2014 I wrote about the possibility that such a situation may play out in 2015.
Opportunities may exist in battered markets
Sentiment for other major currencies, energy, precious and non-precious metals could not be much worse than it is now. Cautious contrarian investors may find opportunities in the extreme negative sentiment. Certainly many natural resources companies have much more attractive valuations now than they did several years ago. Commodities themselves may also offer more value at these price levels than they did in previous years. Both as a hedge against inflation and a bet that resource consumption will increase in years to come.
Meanwhile US dollar trend followers may pile on to what appears to be a massive multi-year rally in the US dollar index or short other currencies, commodities and similar assets. There already exists an enormous amount of speculative betting on the dollar surging higher and other dollar priced commodities and foreign currencies tumbling. This positioning leads me to believe that we may be closer to a high in the US dollar rally than a base to move higher from.
Thus far the US dollar index on a long term technical basis appears to have made a series of lower highs and lower lows stretching back to the rally in the mid-1980s (see above chart) which began as a result of massive interest rate increases by the US Federal Reserve. In order to break this downtrend the index would have to rally beyond 120 and sustain itself there. Only then would I feel that the US dollar has decisively entered an uptrend. That has not happened yet.
The range bound US dollar index
As of the last 10 years we find the US dollar index trading within a range between 72 and 100 (see chart below) which may continue for some time if there isn’t an outside catalyst. Ultimately I believe the US dollar index is headed for a lower low when the current rally stalls further and then reverses lower.
One must remember that the US dollar index is a trade weighted currency basket that measures the dollar vs. the Euro, Yen, Pound Sterling and does not necessarily directly reflect the purchasing power of the US dollar other than when buying these currencies. In addition, the US dollar index has enjoyed its current rally largely on expectations of a widening interest rate differential between the US Federal Reserve and other central banks.
Will the September hike come to fruition? Is it meaningful?
The Federal Reserve has repeatedly delayed its much anticipated interest rate hike, setting expectations that such an event may occur this September — and only if economic data fits their ever moving target. Given the mix of economic data (both good and bad), combined with the backdrop of a significantly weaker Euro and the US dollar beginning to impact multinational companies earnings, I would be surprised if the Federal Reserve set its sights on a heightening cycle. Perhaps a few increases to placate the financial media. But a significant normalization of interest rates would likely have catastrophic effects on multiple asset markets, including mortgages, bonds, stocks and interbank financing.
Up until 2008 the Federal Reserve largely followed the US Treasury 3 month bill rate — rather than vice versa. This meant that interest policy was apparently largely set by the 90-day Treasury Bill market. See the chart above for a visualization of this trend.
Where there was once rate guidance there exists only volatility
Below you will find a chart of the 3 month Treasury bill rate graphed from 2000 to present. In that chart one can see that the same dynamic may no longer exist. That is to say that the 3 month Treasury bill rate is extremely volatile and has been since 2008. Is this an unintended consequence of quantitative easing and zero interest rate policy? Is the Federal Reserve now without guidance from this critical interest rate setting market? Or is the paradigm shift one where the Federal Reserve will now lead where the markets once did?
Much as the rate heightening cycle in 2004-2007 set off a powder keg of insolvencies related to highly leveraged speculative bets imploding, I believe any similar rate heightening cycle this time around will have equally disruptivbe, if not worse, consequences. But it’s anyone’s guess at this point. As you can see we are largely in uncharted territory.