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Commentary & Analysis
Dotty confusi-nomics and the dollar.
I watched America’s lead economist—Fed Chairman Janet Yellen—talking about the economy yesterday; and after she was done I was more confused than when she started—but was happy with the outcome as our subscribers and I were long the British pound.
This is what I heard from Chair Yellen: The US economy is doing well; but not that well. Inflation isn’t a concern, but we should be concerned as its ticking higher. Global economic turbulence is dragging down our dots, but a strong US labor market should allow us to hike soon.
So, the dotty takeaway—two hikes instead of four.
So, the US Federal Reserve Bank will only hike twice during 2016. This compares with an expectation of zero hikes, and possibly more cuts, from both the Bank of Japan and the European Central Bank this year. It means the US dollar yield premium is likely to rise sharply against the yen and euro as the year progresses. Knowing that, what should one do? Well, the answer is obvious: Sell the living bejesus out of the dollar, of course.
The dollar was creamed on the news. And continues to get hammered one day after Janet’s lesson in confusi-nomics…but is this an opportunity for those who believe the real economy matters? Maybe so!
There a simple framework I keep in mind when watching the news and thinking about the currency market. It is called The Dollar Smile. I first saw this in a research note writing by Stephen Jen, when he was with Morgan Stanley—a firm that does great currency research IMHO. The Dollar Smile looks like this:
Three scenarios gleaned from the dollar smile:
- Left side of the smile reflects an appreciating dollar as global risk comes back into the financial system. Despite the ongoing problems facing the US economy and the much talked about structural problems that are supposed to hurt the dollar, e.g. budget deficit, trade deficit, etc. the dollar could rally significantly if there’s a shakeup to the global financial system and risk increases outside the United States, as money flows back to the center to hide in US deep capital markets—think about that $3 trillion or more in emerging market debt flowing in on contagion. Well, I thought Janet & Company told us there was a lot of concern about global markets?
- The middle of the smile reflects dollar depreciation against the major currencies as the US economy muddles through soft spots. Implicit in this view is ongoing weakness in the US economy led by a consumer that capitulates to falling housing prices, rising energy prices and too much debt, etc., etc., rising possibility of a pending US recession or downward growth surprise. This would shift the expectation among currency players for a Federal Reserve Bank “on hold” to a Federal Reserve Bank in “cut mode” going forward. But I thought I heard Janet & Company say the US economy was doing well relative and the labor market was still improving nicely?
- The right side of the smile reflects an appreciation in the dollar on the back of strong US growth. This is the rising yield differential stuff that pulls in hot money and a greater share of foreign direct investments as the US economy grows faster than key competitors and the Fed is planning to hike—which is self-reinforcing. Well, if I am not mistaken, even though the dots have fallen, they are expected to get up—leading to two more hikes this year, as said above, which means strongly rising relative yield differential given the BOJ and ECB will most likely not be hiking again in our lifetime.
So, based on the framework of the Dollar Smile, it adds to my confusion as to why many have jumped back onto the dollar bull market is over bandwagon. I don’t think it is over. But I do believe in self reinforcing price-driven trends that can run further than fundamentals would suggest. And given my expectation of a rally in commodities (oil and gold)—which I shared with you a couple of weeks ago—I think this has more to do with dollar weakness than anything we can actually glean from the country’s top economist.
So here is my best guess on a downside target for the US dollar index if this commodities move remains intact:
A 38.2% retracement of what I have labeled as Wave 3 rally means the dollar index falls another 2.5% from here—92.21. Obviously, there is plenty of scope for more. And that fact has the dollar perma-bears and the gold perma-bulls pretty excited right now. Stay tuned.