Is this the beginning of trend USD strength?

Is this the beginning of trend USD strength?

The big news catching my eye this morning is the strength of the US dollar. While last night’s catalyst was commentary from San Francisco’s Federal Reserve, suggesting markets were not adequately pricing in the US interest rate recovery story, really what we’re seeing is a bull market – that has been selectively digesting US economic recovery data in a rather optimistic way – begin to focus a little more seriously on the potential for higher US rates. I don’t believe that the market is in disbelief that US interest rates will begin to rise at the hands of its central bank; rather, I believe that traders have been making hay while the sun shines with long risk trades in a market that has plainly been rewarding them to do so.

A stronger euro last night muddied the picture a little if we are to look at outright US dollar index (Rivkin Trader: USDINDEXSEP14) strength for signs of a trend, with the large euro makeup of that basket stopping the index from advancing overnight. In other currencies more sensitive to carry trades (whereby one benefits from selling the US dollar to fund the purchase of a currency where interest rates are higher), we did see some action last night. The AUDUSD currency pair extended this week’s loss be trading at US$0.9203, down from Monday’s high of US$0.9373. The US dollar versus Japanese yen (USDJPY) is also on the move, extending a significant trend that began in early August 2014 – one month ago the US dollar was buying 102.18 yen, today it will buy you 106.21.

So I revert to my original question, is this the beginning of trend USD strength? There are certain macro trend trades that hedge fund managers like to identify and sometimes make their retirement from – the most recent example would be the effect that Shinzo Abe’s quantitative easing in Japan had on the yen, Japanese Government Bonds and the Nikkei 225, following his 2012 general election victory (please see the first chart for an illustration, note that the absence of a third vertical axis exaggerates the move in JGBs, but shows the behaviour nonetheless). The most notable period of this ‘trade’ was the Q4 2012 to Q2 2013 trend, whereby traders jumped on short yen trades and long Japanese equity trades and made a lot of money in the process. There’s no doubt that the same savvy hedge fund managers will be watching for a similar opportunity to jump on trades that will benefit from rising US interest rates. However, I don’t believe that now is the right time to assume we are at the beginning of this trend. It may be time very soon, but for now the noises coming from officials are likely warnings over the bow, not necessarily enough to shock markets into submission.

There is no doubt that any prudent central bank official would be wise to continually warn and test markets to ensure that they begin to lose their complacency and ready for higher US interest rates; however, the US S&P 500 (last week breaking new highs, again) isn’t representative of ‘main street’ America. On the one hand improving GDP growth and falling unemployment rates in the US are a positive, but, on the other hand, would it be wise to tinker aggressively with interest rates and interest rate expectations now when they are FINALLY (after five or six years) beginning to actually help the economy? The US inflation rate is at a healthy 1.9% and seems to have shaken some of the volatility from earlier in the year, but it is by no means showing signs of being out of control, and falling oil prices will slowly feed through to core CPI and could keep a lid on inflation.

The second chart shows the performance of the New Zealand dollar, Australian dollar and Canadian dollar versus the US dollar, over the last three months and in percentage terms. With particular regard to the Australian dollar’s dive over the last two sessions, these ‘risk’ currencies are showing signs of weakening as the expectation of changing interest rate differentials between the US and these countries dissipates. Again, I see these currencies as good indicators to view the market testing the beginnings of a reversal that saw the Australian dollar recover so strongly after the GFC, but I don’t necessarily see a low risk opportunity to bet on the beginning of a downward trend here. The NZDUSD currency pair is a bit of an exception, given falling milk prices there as well as the combination of New Zealand’s rising interest rate cycle and benign inflation rate – inflation there continues to wallow at 1.60% versus Australia’s 3.0% and Canada’s 2.10%.


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