Dollar Supported by Economic and Geopolitical Developments

December 17, 2014

Plunging Oil Prices:   As Fed Chair Yellen opined today, oil prices have declined substantially in a short period of time, surprising the FOMC and most of the financial markets with the abruptness and severity of the the drop.  There are numerous and mixed ways that such a change will affect the U.S. and other economies.  On balance, the drop appears to be “net positive” for the United States.  Economically, the U.S. is still a net importer of oil, so the trade deficit will lessen other things the same.  Headline and even core U.S. inflation are being reduced, cutting long-term interest rates and expectations of the nearness of a lift-off in the federal funds target.  The U.S. is less exposed than most other advanced economies through trade and financial channels to the great distress being imposed on the Russian economy.  From a geopolitical standpoint, the turn for the worse in Russia’s situation seems almost too good to be true, so much so that in light of recent revelations about CIA behavior, it would hardly be surprising to learn years from now that U.S. intelligence agencies have had a hand somehow in transforming a moderate market-based adjustment to shifting oil supply and demand into a much more dramatic sell-off.

More Supportive U.S. Balance of Payments:  A continuing U.S. economic expansion and strengthening dollar have not put observable stress on the balance of payments.  On the contrary, the current account deficit in the third quarter of $100.3 billion equaled a manageable 2.3% of GDP, same as in the second quarter and down from 2.4% in the first quarter of this year.  More importantly, long-term capital movements related to direct and portfolio investment flows swung from a net outflow of $141.2 billion in the second quarter to a net U.S. inflow of $69.2 billion in the third quarter.  The main factors behind this improvement were a reduction in U.S. net buying of foreign bonds to $26.0 billion from $104.0 billion, increased foreign purchases of Treasury, agency, and corporate U.S. bonds to $163.3 billion last quarter after $64.3 billion in 2Q, and net purchases of U.S. equities by foreigners totaling $84.6 billion  in 3Q after purchases of just $3.4 billion in 2Q.

Even More Benign U.S. Inflation:  Headline U.S. consumer price inflation fell 0.3% on month in November and by 0.7% at an annualized rate between June and November.  Core CPI inflation was 1.7% over the past twelve months but a significantly lower 1.1% annualized over the last five months.  The topic of falling inflation compensation in financial markets was raised repeatedly in Yellen’s press conference, and the Madam Chair stressed that an initial interest rate hike will not likely be attempted until officials are much more confident than now that their theory-based forecast of an eventual rise in inflation back to the 2.0% goal is happening even if monetary accommodation starts to be withdrawn.  Monetary officials lowered their projected range of PCE inflation next year to 1.0-1.6% from 1.6-1.9% predicted three months ago, and projected core PCE inflation was also trimmed by 0.2-0.3 percentage points in the latest forecast.  It’s one thing to have benign inflation, but quite another to have deflation or be in significant danger of developing such.  The U.S. fits the first description, unlike Japan and much of Europe that’s in the other troublesome position.

The Fed is the Investor’s Friend:  The FOMC’s message was hardly changed.  The forward guidance language got tweaked, but it was stressed that the modification does not signify any departure from the intended message of the previous language used.  The earliest implied timing of normalization lift-off seems to be almost a half year away, and the ensuing path of U.S. interest rate rise is lower.  The released scatter diagram of policymaker future interest rate expectations now has an end-2015 range-median of 1.125%, down from 1.25%, an end-2016 rate level of 2.5%, down from 2.75% projected back in September, and an end-2017 rate of 3.125% versus 3.75% predicted just three months ago.  The Fed is going to keep policy accommodative for several more years.  Now one often thinks of lower interest rates as currency-supportive, but the United States doesn’t need a rapid or cumulating rise in short- or long-term interest rates for the dollar to appreciate.  The U.S. rate spreads with Europe and Japan will be widening, and a gradual normalization of U.S. rates is a sign of strength, not weakness.  Economic conditions are allowing the Fed to proceed cautiously, reducing the chance that the U.S. expansion will not be able to tolerate this coming transition.

Safe Haven Demand:  The world remains a dangerous place, prone to war, drug-resistant microbes, catastrophic climate change, and financial market meltdowns.  Even when the U.S. economy is troubled, capital flight generally like the haven offered by the depth and consistency of U.S. assets.  Relatively better economic prospects in the United States is mere icing on the cake for safety-conscious investors.

Dollar Not Overbought:  The dollar remains marginally softer than its post-1998 average of 1.2257 per euro.  Dollar/yen since the start of 1987 has averaged 113.0, only 5.0% weaker than the current level.  In trade-weighted terms, the dollar is still 31% weaker than its July 2001 peak.  Even with omnipresent reserve asset diversification, a dollar negative, plenty of scope exists for a cyclical, and even a secular, rise in the U.S. currency’s external value.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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