Why Might the Dollar Uptrend Be Stalled?

July 21, 2015

On paper, prospects for dollar appreciation continue to look very sound.  Monetary policy cycles will be extremely disparate over the next two years between the United States on the one hand and the eurozone, Japan and emerging markets on the other.  Gold’s relentless slide suggests considerable continuing confidence in a dollar uptrend, especially in light of the abundance of geopolitical dangers and financial asset bubbles that ordinarily ought to be stimulating demand for precious metals.  In the five years of the eurozone debt crisis, Greece had been portrayed as the rule breaker and weak link, but the last two weeks changed that dynamic profoundly.  Germany has instead been on the receiving end of brutal worldwide commentary.  In a back to the future fashion, the predatory monster depiction that once defined Germany’s behavior toward other nations has been resurrected.  And since Germany has been Euroland’s flag-bearer, this development darkens how the world views the European Economic and Monetary Union.  The eventual break-up of the common currency area remains as plausible as ever, tarnishing the euro’s appeal as a long-term store of value.  Meanwhile, doubts persist about the effectiveness of the Japanese government’s efforts to eradicate deflationary psychology, and other misgivings surround views on China’s economic outlook.

One of the most valuable lessons for anybody who wishes to make a living in foreign exchange is that no matter how compelling a currency story seems, fundamentally or technically, the greatest information is often gleaned from watching how markets react to news rather than how one expects currencies to be responding.  The hard truth lately has been that the dollar is having a very difficult time indeed strengthening past 1.05 per euro and  JPY 125.  It may be a matter of time, or it may reflect a factor that hasn’t been in the direct spotlight.  Such a factor is the trend in balance of payments.

The U.S. current account deficit, 2.2% of GDP in 2013 and 2014,remains low by 2006-2008 standards.  In those three successive years, the deficit has climbed to 5.8%, 5.0% and 4.7% of nominal GDP, respectively.  But the deficit in the first quarter of this year inclined nonetheless to 2.6% of GDP, and the effect of that upswing on U.S. economic growth can be further gleaned from the fact that the drag from net exports on U.S. economic growth has exceeded a percentage point in three of the last five reported quarters:  1.66 percentage points (ppts) in the first quarter of 2014 (1Q14), 1.03 ppts in 4Q14 and 1.89 ppts in 1Q15.

The current accounts of Japan and the eurozone have improved meanwhile.  Japan’s seasonally adjusted current account surplus in April-May of 2015 soared to 17.5 trillion yen at an annualized rate from 7.8 trillion yen in fiscal 2014 (year to March 2015) and 1.5 trillion yen in fiscal 2014.  Turning to the eurozone, the current account in the twelve months to May 2015 rose to EUR 249 billion from EUR 180 billion during the previous twelve-month period.  Net direct investment inflows more than doubled to EUR 100.6 billion from EUR 41.7 billion, and net long-term portfolio capital shifted from a outflow of EUR 95.1 billion in the twelve months through May 2014 to an inflow of EUR 100.6 billion in the ensuing twelve months to May 2015.

Substantial currency movement has already happened to generate these balance of payments changes.  The trade-weighted dollar is 25% stronger than its 2009-13 average level, which is akin to an interest rate change of almost three percentage points.  The trade-weighted pound has also risen, climbing almost 17% versus its 2009-13 mean.  In similar temporal comparisons, the trade-weighted yen, Canadian dollar and euro have weakened by around 24%, 17.5%, and 12.5%.

Over the balance of the summer and next fall as Fed tightening becomes a fact and not just an expectation, the dollar may indeed but through the aforementioned barriers of JPY 125 and 1.05 per euro.  If that doesn’t happen, analysts will be scrambling to explain why not, and this not offers one plausible answer.

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

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