The US dollar: where is it going and why?

The US dollar: where is it going and why?

The first two charts below represent the US dollar index and its rise from mid-2014 until now, first in terms of the index level itself, second in percentage terms relative to where it began on 30 June 2014. A strong theme emerged in 2014, as was directed by US Federal Reserve language combined with tapering of its asset purchase program, which led markets to believe that the US Fed Funds rate would begin to rise imminently. It shouldn't be downplayed that, in chorus with rising interest rate expectations, the Fed’s tapering of its bond purchases slowed the expansion of its balance sheet and thus the increasing reserves that banks were able to lend against. For this reason, a strengthening of the US dollar was a fundamental response to tapering, as well as a forward-looking response to expected rate rises.

It is important that investors and traders focus on the effects that have come from the removal of quantitative easing when deciding when the US dollar goes next. Why? Well if you look back far enough (the 1995 – 2002 rally in particular on the third chart), you can see times when the US dollar index has rallied for significant lengths of time and many traders will tend to take a look at current strength and assume that it will carry on exponentially. So being aware that the removal of a huge bond purchase program in 2014 was a contributor to this US dollar strengthening trend is important.

Source: Rivkin Trader, Saxo Capital Markets, 27/02/15

So with the brief history of where the US dollar has been covered off, let’s move onto where it might go now. The US Federal Reserve knows very well that talk of higher interest rates has helped elevate the level of the US dollar, which - as a result of the relatively healthy terms of trade in the US - will begin to bite a little into the US economy, given the recovery in its manufacturing and exports. A low US dollar has assisted US businesses in on-shoring a lot of manufacturing and services, and the low interest rates that have accompanied it have also allowed the US Treasury to refinance debt at very low rates. This is particularly important as the total outstanding public and intragovernment debt figure in the US is US$18 billion as at the end of January 2015. Right now the US Treasury department can issue new bonds against a backdrop of 10-year bond yields of 1.68% and this allows them to keep a lid on interest rate payments to investors. If, however, interest rates were to rise quickly before the government has a chance to allow its expanding economy to begin paying down its debt to a reasonable level, the interest expense would overwhelm the government budget.

For these reasons, I believe that the US Federal Reserve will use the slack in the economy and the ensuing below-target inflation levels to draw out the exercise of raising rates for as long as they comfortably can. This will likely keep the US dollar on hold (trading sideways until a rate-hiking theme emerges) and it will also have the effect of taking the focus away from a widening interest rate differential between the Australian dollar and the US dollar, which will also support the Australian dollar due to its outright high yield from 2.00%+ cash rates.

While there has been much talk of a US interest rate hike (singular), much of this is due to the intense political pressure coming from the US Republican Party, which wants an end to zero interest rate policy – probably because it’s working and they’re not in government to take credit right now! Even if there is a hike, it is highly unlikely to precede a ‘hiking cycle,’ because inflation in the US is not ‘trending’ higher. In fact, the annual rate of inflation has been falling in chorus with weaker oil prices and a strengthening dollar (which are both disinflationary).

So in summary, while oil prices remain low, wage growth is barely moving and plenty of ‘underemployment’ belies the very low headline unemployment figure in the US, I believe that the US dollar will continue to track sideways which will allow other currencies and commodities that trade against it to potentially benefit.
comments powered by Disqus

DISCLAIMER: Rivkin aims to provide clear and simple information to those visiting our website. If any part of this disclaimer does not make sense, please phone Rivkin and ask to speak with a member of our Dealing and Relationship Management Team. Rivkin provides general advice and dealing services on securities, derivatives and superannuation (SMSF). Rivkin also provide SMSF administration and accounting services. Rivkin does not provide advice that takes into account your, or anybody else's, investment objectives, financial situation or needs. We strongly suggest that you consult an independent, licenced financial advisor before acting upon any information contained on this website. Investing in and trading securities (such as shares listed on the ASX) and/or derivatives (such as Contracts for Difference or 'CFDs') carry financial risks. CFDs carry with them various additional risks that differ from more simple securities such as fully-paid company shares. Some of these risks include not owning the underlying instrument from which a price is being derived, settling trades 'over the counter' with a financial institution rather than on a stock exchange, and using leverage to gain access to trades that may have a higher face value than your initial deposit. This risk of leverage means that it is possible to lose more than your initial investment. Our aim is to create more life choices for our clients, which means improving the wealth of clients throughout many market cycles by nurturing a relationship spanning many years. If you are not comfortable with your understanding of the risks involved before using a Rivkin product and service, please contact our office to seek further information or a Product Disclosure Statement, or make an appointment to sit with one of our friendly financial experts. It is in our interest for your Rivkin experience to be a rewarding and comfortable one. Rivkin is a trading name of Rivkin Securities ABN 87123290602, which holds Australian Financial Services Licence No. 332 802.