Thursday, September 24, 2020
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The US dollar rally is back on track

The trade-weighted US dollar traded back to a two-month high last week. The recent rally has effectively ended the episode of weakness in late September and much of October after the Federal Reserve shocked the market by failing to “taper” asset purchases at the September 18 FOMC meeting and from the uncertain effects of the US government shutdown episode over the first half of October. The shutdown event was expected to impact the US employment numbers in October, but last week’s delayed US October jobs report showed a better than expected payrolls number and strong revisions to previous months’ data as well. In response, the market is returning to the view that the Fed will look to reduce asset purchases as early as the January meeting — maybe even at the December meeting if the data to that point comes in particularly strongly.

To taper or not to taper?

A large part of the US dollar’s immediate outlook is wrapped up in the on-going debate over the when and whether of the Fed’s asset purchase taper, with the theory that a taper is dollar positive and a non-taper dollar negative. Consensus is beginning to place the timing of the taper at either the January or March Fed meetings, though there is increasing speculation, even if still among a small minority, that the Fed will not taper in the foreseeable future and could even increase purchases on the next bout of economic weakness or, as has become the latest hot topic, on signs that deflation remains a threat.

Regardless, for the Fed, the taper has become a question of “pick your poison”. On the one hand, it is easy to argue that the Fed will never get around to tapering because of the lesson from earlier this year, when the mere threat of a reduction of asset purchases triggered an avalanche in the US bond markets and a huge liquidity pinch on emerging market currencies and economies. An asset purchase taper would risk damaging market confidence and weakening the fundamentals, which already face headwinds due to higher rates (i.e., a de facto tightening) that the taper talk has already engendered. On the other hand, there is increasingly widespread recognition that equity markets are in a bubble, and the need for the Fed to check the rise in assets is becoming increasingly evident, as any severe equity market correction will promptly be placed squarely at the Fed’s feet for having driven a bubble in asset markets in the first place.

Rally continues to accelerate

Interestingly, the Fed’s September backtracking on the intent to taper has only partially unwound the damage to bond markets and emerging market currencies. The US dollar was back higher on Friday’s US jobs report, which seems to have brought forward the Fed’s first taper announcement. If we do see the Fed moving to reduce purchases, we can expect the USD rally to accelerate if higher bond yields and a reduction in the Amazon of liquidity from the US Fed also topple asset markets. The rally will accelerate further still as the USD continues to be sought as a safe haven and as the Fed becomes the first major bank to begin tightening policy.

Gaining on troubles elsewhere

But even without a Fed taper, the fundamentals favour a stronger US dollar as the other major currencies are also beset with their own problems. In Europe, either the ECB joins the currency devaluation game or the spectre of deflation looms, not to mention the accelerating likelihood that the EU periphery — or even France — will threaten at least a holiday from the Euro single currency in order to devalue if policy doesn’t soon change. In the UK, the recent economic strength and sterling strength has been driven by the UK government encouraging UK households to sink further into debt with cheap home loans.

Meanwhile, in September, the UK posted one of the world’s largest trade deficits, which is being partially offset by huge capital flows into the extremely bubbly high-end UK and London housing market. Look for the BoE to lean against sterling strength soon.

In Switzerland, expect an SNB response if deflation signs deepen, and for a sudden weakening in the franc if the ECB moves more firmly to back up peripheral sovereigns.

In Japan, the BoJ is the central bank most intent on destroying it currency and will be the first to take monetary policy to new extremes if — or as I would argue when — its initial policy push inevitably fails. As an aside, it will be interesting if USD/JPY heads lower first in the recognition that Abenomics isn’t doing enough for Japan, thus triggering the next aggressive move from the BoJ or even more interestingly, from the Abe government. The “right way” to effectively destroy a currency is through government money printing to fund activities, not through central bank asset purchases.

There may be another hiccup or two of USD weakness into the end of the year as taper expectations wax and wane, but the US dollar is firmly back on the rally path and is likely to have a very strong 2014.

— Writer is head of FX Strategy at Saxo Bank