Q1 was a difficult quarter for those of us who entered 2016 in a bullish mood for the US dollar. The rate rise in December by the Federal Reserve was, to us at least, a natural conclusion to a strong year of economic progress and the natural, albeit slightly tardy, beginning of a policy of rate normalisation by the world’s most important central bank.

The world has lost momentum since the turn of the year with the loss of impetus in the US economy the most challenging to explain and difficult to quantify; wage growth is not as forthcoming as it should be given the tightness of the labour market, manufacturing and industrial output has slowed, and the greatest engine of economic prosperity, the US consumer, is not spending as they should be.

Jeremy USD

Graph used with permission of Bloomberg Finance L.P.

Markets have been made restless by a variety of influences and a siege mentality has set in within the Federal Reserve. While a large part of the market fear that we have seen this year can be attributed to doubts over the efficacy of negative interest rate policy, crosswinds from poor bank earnings, continued uncertainty over the path of commodity prices, and listless global growth have clipped the dollar’s heels. Through the global financial crisis the dollar would tend to outperform in these circumstances; however,
risks have shifted sufficiently that it can be the US dollar that is tagged first when the storm clouds roll in.

It is our thought however that the next 8 months will provide ample opportunity for the dollar to strengthen.

Take EURUSD for example. European Central Bank policy has been disappointing this year and the pricing out of US rate hikes has seen a natural rally in EURUSD. ECB President Mario Draghi told reporters that “from today’s perspective, and taking into account the support of our measures to growth and inflation, we don’t anticipate that it will be necessary to reduce rates further.” This took out one of the tenets of EURUSD weakness and implicit USD strength.

In the meantime, I have to think that the range trading and bumbling around will continue until a wider pick up in US data manifests itself. I think that this is likely as we move into Q3 and that is when the USD could, and should, outperform.

As for when the next Fed rate rise might happen, I’m still looking at September. I was slightly disappointed by the March U.S. inflation figures. The U.S. jobs market is going gangbusters at the moment and has been for a long time. But unless it translates into wage growth, then these are somewhat meaningless numbers. The world needs to see that second round effect through wages and a pickup in productivity for it to be really the silver bullet that policy makers are looking for. I would hope that, with the tightness in the labor market, it would start to come through in the third quarter and therefore lead to a September rate rise.

Jeremy USD_2

Graph used with permission of Bloomberg Finance L.P.

Boston Fed Chair Eric Rosengren hit the nail on the head recently by saying that “the very shallow path of rate increases implied by financial futures-market pricing would likely result in an overheating that necessitates the Fed eventually raising interest rates more quickly than is desirable, which could endanger the ongoing recovery and continued growth.” A sudden repricing of a rate hike could be rather spicy; there is only a 13.7% chance of a hike in June and a 35.8% chance of a move in September. That’s a lot of room to run.

While everyone waits on that, our focus will shift to political matters with the rise of Donald Trump only just making its way into the Top 3 of political risks for 2016. While ‘The Donald’ is attempting to Make America Great Again, the UK’s referendum on EU membership is threatening to Make Europe Hate Again.

I think that the chances of the UK electorate actually voting for the UK to leave the EU is relatively low, somewhere around the 25/30% mark. Opinion polls have a majority of respondents voting to Remain. Polls have been wrong in the past of course and if they are we are likely to see a dramatic jump in the USD. For now, as one can see from the graph below, the pound is a lot lower than it should be under typical market conditions.

Jeremy USD_3

Graph used with permission of Bloomberg Finance L.P.

Even in the event of a Remain vote within the UK referendum, I fully believe that once it’s all said and done in the U.K., regardless of the outcome, within the next 18 months or two years we will see similar referenda take place in other European nations. We know the French have been talking about it, we know the Dutch have been talking about it as well. It’s been a rocky political arena in Europe since the advent of the global financial crisis, but the rise in populism does lend itself to a new, maybe isolationist, politics within the European Union, and that’s something we really need to be fearful of. This creates another EUR risk heading into the 2nd half of the year and we haven’t even talked about another summer of Greece headlines. You would have to think these raise the risks of USD strength.

China has been one of cradles of economic negativity since last August when it unexpectedly revalued the yuan. While I remain of the view that Chinese growth will struggle, policymakers face a likely choice to continue the depreciation of the yuan; a benefit to the dollar.

I also see USD appreciation against emerging market currencies in the coming months although opportunities must be split here. On the one hand, there are the dogs of the FX world (ZAR, BRL and PLN) that have underperformed in recent months courtesy of unsustainable policies and the doubts over the political regimes of the countries. On the other hand, countries that have been better at managing current account and debt positioning such as MXN, INR, IDR.

The US economy and the US dollar may have false started in the early part of 2016 but there is a very good chance that the rest of 2016 is a lot smoother for the greenback and I would be looking for a rebound higher for the dollar.