Dollar Recovery in a Lull

April 16, 2015

Coming into April, the dollar had experienced a rally of historic proportions, topped off by advances of more than 9.0% in the first quarter against the euro, yen, Swissie and both Canadian and Australian dollars.  In the current month, however, upward dollar momentum has slowed substantially for a variety of reasons.

A broad spectrum of U.S. economic indicators have performed more weakly than expected.  A 126 thousand worker increase in March was the smallest monthly rise in nonfarm jobs since 2013.  Drops in industrial production of 0.4% in January and 0.6% in March sandwiched a 0.1% uptick in February.  Retail sales fell by 1.3% last quarter (-1.6% on core items).  Factory orders in January-February were 5.4% lower than a year earlier, and purchasing manager differentials in both manufacturing and services between the United States and eurozone have recently converged dramatically as documented in an earlier update on this site.

A separate survey suggests that expectations have also converged about growth 1-2 years from the present.  Every month, The Economist conducts a survey of forecasters’ growth, inflation and current account expectations, and this feature introduces the year after the present one each March.  In the April 2014 survey, the growth forecasts for calendar 2015 were 3.0%, 1.5% and 1.4% for the United States, eurozone and Japan respectively.  In the April 2015 survey, 2016 growth forecasts for those three economies are 2.8%, 1.7% and 1.7%.  While the United States is still projected to command a wide growth advantage in the year after this one, analysts are slightly less optimistic for the 8-20 month time horizon about the United States but have also become a bit less pessimistic about prospects in Japan and Euroland.

The poorer U.S. data have intensified debate about how soon the Federal Reserve will begin raising interest rates and whether it should be tightening.  FOMC members have voiced a diversity of opinions, but the impression remains intact that the onset of rising short-term interest rates will lie sometime between June and September, which is a comparatively compressed window of time.  So a rate hike relatively soon is baked into expectations, and it will be happening even as quantitative stimulus in Japan and the eurozone continue.  That contrast of policies has been a major driver of the dollar’s rally since the second half of 2014.

The dollar strengthened even though oil prices were plunging.  As an energy producer, elevated energy costs favor the U.S. economy vis-a-vis those that depend entirely on imports for their energy needs.  Ironically, the dollar’s April pause has been juxtaposed against a 30% recovery in West Texas Intermediate crude from 42.65 per barrel on March 17 to $55.65 per barrel at present.  But the effect of changes in the cost of oil on movements in currency values is a lagged process, so the previous plunge of oil costs, a dollar negative, would seemingly be more influential now than the fact that oil prices  firmed during the past month.

Long-term interest rate differentials will exert an important influence over the dollar during the rest of this year.  Ten-year bond yields fell sharply last year, dropping about 95 basis points in the United States, 126 basis points in Germany, and 23 bps in Japan.  The first quarter saw German bund yields tumble more than twice as much Treasuries (36 basis points versus 14), while Japanese JGBs climbed eight basis points.  But this month, yields in Japan and Germany are thus far down almost ten basis points, while U.S. rates have bounced around in a directionless way.  It can be said that very depressed yields in other economies are keeping Treasury yields level even as the long-awaited moment of Fed tightening draws nigh.  The failure of U.S. long-term rates to incline as the Fed transitions from an ultra-accommodative stance to one that is becoming gradually less so is a departure from the historical norm.  If this disconnection were to persist even after the first rate hike, a key assumption behind the dollar’s appreciation since mid-2014 could be called into question. 

The stalled dollar uptrend may in part reflect psychological resistance around some key levels.  Against the euro, the dollar ran out of steam right after moving to within a nickel from parity, touching a high of 1.0459 per euro on March 16.  And since first visiting JPY 120 at the end of 1987, the dollar has become bogged down near that threshold several time when approaching from either the north or the south.  120 per dollar is not the average level over this span, which is 111, but it has repeatedly exerted considerable gravitational force on USD/JPY when the relationship draws nearby, and penetration through that threshold hasn’t come easily.

None of the above developments is a huge shift, and it usually takes something more profound to end and reverse a dollar trend that’s been as powerful as the rise through mid-March.  On the other hand, given the historical magnitude of the dollar’s appreciation in so short a span of time, a pause or even a correction at this juncture seems reasonable. 

There are some wild cards that could transform market focus to consider as well.  For Euroland, the Greek debt crisis is fast approaching a flashpoint that could result in a very bad outcome, a postponed reckoning that buys more time without fixing underlying imbalances, or, least plausible of all, a true breakthrough.  In Japan, Prime Minister Abe and BOJ Governor Kuroda have had a falling out over policy priorities and the appropriate behavior of the yen going forward.  Disputes between politicians and central bankers often create selling pressure for the currency caught in the middle.  Finally, Group of Twenty central bankers and finance ministers is meeting today and tomorrow.  The G20 inherited the role of coordinating currency policy from the G7.  Policy matters a great deal in determining foreign exchange values, and the G7 several times influenced the major trading currencies in very significant ways.  The G20 has been much less coherent and consequently less influential on life in the currency trenches.  But the finance ministers and central bankers are meeting at a time when currency movement has been the lead financial market story, and a surprise initiative shouldn’t be ruled out.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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