This Is Why The Dollar Will Rally This Year

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Coronavirus impact: Dollar, equities and gold rally; why 2020 could be a year of rate cuts

The demand for the Japanese yen often increases amid rising risks to economic growth.

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The historical correlations between various asset classes look disrupted as investors are finding it difficult to price risk to global growth due to the Covid-19 epidemic. The impact of the SARS outbreak in 2003 may not serve as an effective proxy since China’s contribution to the global gross domestic product (GDP) has increased four-fold since then. As a result, investors are turning to safe haven assets to cover economic risks.

According to Bloomberg Economics calculations, China’s economy is running at 40-50 per cent of its capacity, and the first-quarter GDP growth may drop to 4.5 per cent, the lowest since 1992.

The US dollar and gold, which typically move in opposite directions, are both on an upswing amid the search for safe havens. This has resulted in the weakest negative correlation between these two asset classes in eight years. Gold is at a seven-year high of $1,600 per ounce. The dollar index, which tracks the performance of a basket of leading global currencies with respect to the US, has inched up to nearly 100 from 96.5 at the beginning of 2020. The dollar is strengthening with a flush of money moving towards US assets, both in fixed income and equities. The ratio of the MSCI US index to MSCI World index, excluding the US, rose to a record high of 1.6.

.#Dollar #DXY index traded this morning at its highest level for almost three years–not just confounding consensus… https://t.co/C8yQtYQ1Zy

The bond and equity markets too are rising in tandem. The correlation between the US 10-year treasury yield and S&P 500 index has reached the highest level in a decade. Moderation in the global economy implies that global central banks may turn more accommodative. The probability of an interest rate cut by the US Fed during its meeting in the second-half of 2020 is more than 50 per cent.

The demand for the Japanese yen often increases amid rising risks to economic growth. This time around, however, bearish bets on the yen have risen the highest in 16 months on the expectation that the virus outbreak could put the Japanese economy in recession phase.

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This Is Why The Dollar Will Rally This Year

Wage Inflation Will Move The Dollar

The US non-farm payrolls report was released today and was much as expected. Job gains were strong, unemployment is low and wages continue to rise. While several points within the report were tepid compared to expectation there is one that will move the dollar; average hourly earnings. Average hourly earnings rose by 2.9% in the past month and show no signs of abating.

The NFP shows an increase of 204,000 jobs that, with revisions to the previous month, has resulted in average gains of 185,000 over the past twelve months. Based on other data points from the labor market this trend is going to continue at least into the end of this year. The labor market is tight, there are far more jobs than workers, and that means one thing; upward pressure in wages and that is what we are seeing.

Regarding forward outlook, the Index of Leading Indicators has been positive for more than two years and came in above expectation at the last read. This, along with increases in both the manufacturing and services sector PMIs, points to accelerating growth in the second half of this year. Accelerating growth is a situation that will add upward pressure to wages as employers do whatever it takes to attract and retain employees.

The key takeaway is that wage inflation is running near 3.0% and well above the Fed’s target rate. While not the only input regarding core US inflation it is a very important part of the picture. Core inflation has been on the rise this year and will soon cross the 2.0% level. If the FOMC wants to curb inflation they will have to act to control economic growth and that means rate hikes, more rate hikes than what the market had been expecting.

The EUR/USD fell hard on the news, shedding more than 50 pips in a matter of minutes to create a long red candle on the daily charts. The move has confirmed resistance at the 1.1625 level and may take the pair down to support targets near 1.1525 and 1.1400. Next week there are a number of US data points including the PPI, CPI and FOMC Beige Book that could add downward pressure to this trade.

4 reasons why the US dollar is unlikely to rally this year

The US dollar has been the whipping boy of currency traders over the past year.

In 2020 alone, the US dollar index, or DXY, fell by 10%, losing ground against all major currencies. And that weak performance has carried over into the early parts of 2020 with the DXY down a further 2%.

However you chose to describe it — be it relentlessly, monotonously or other — the US dollar has come under significant selling pressure.

Put simply, it just can’t find a friend.

Elias Haddad, Senior Currency Strategist at the Commonwealth Bank, says the US dollar is unlikely to find many new friends in the year ahead, either, but thinks the chances of a short-term bounce in the DXY are increasing given market sentiment and positioning are all stretched in the same direction.

“The USD is vulnerable to a technical relief rally in the short-term but we continue to expect the USD to trade on the defensive this year,” he said in a note released earlier this week.

In particular, Haddad nominates four specific factors that will likely weigh on the greenback: weak inflationary pressures, further rate hikes from the Fed already factored in to the dollar’s valuation, a move towards less accommodation monetary policy settings from other major central banks and an improvement in the global economy, something that tends to weaken, rather than support, the DXY.

On the inflation outlook, Haddad says soft inflationary pressures will not allow for markets to price in additional rate hikes from the Federal Reserve.

“Benign US inflation pressures will limit a significant upward revision to US interest rate expectations,” Haddad says, noting that the Fed’s preferred inflation reading — the core PCE deflator — has been below the Fed’s 2% objective since May 2020.

“Interestingly, the FOMC still projects the core PCE deflator to only reach 2% in 2020 even when accounting for the prospect of greater fiscal stimulus.”

Along with weak inflationary and wage pressures, Haddad says the US dollar is unlikely to get much support from further rate hikes from the Federal Reserve.

“Fed funds rate rises are largely priced,” he says. “Fed funds futures have fully discounted two 25bps rate hikes for 2020.”

And even if the Fed is more aggressive, delivering three hikes as it did in 2020, Haddad still doesn’t think it’ll be enough to support the dollar.

“The FOMC can potentially deliver three 25bps rate increases this year. But one more rate rise than is currently priced-in will not be a major sustained tailwind for the USD,” he says.

And with each rate hike from the Fed taking it closer to the end of its monetary policy tightening cycle, Haddad says other major central banks are just embarking on that path, something that he expects will continue to support other major currencies to the detriment of the dollar.

And that’s especially for the euro, the largest component in the US dollar index at well over 50%.

“There is greater scope for less monetary policy accommodation from other major central banks,” says Haddad.

“For instance, Eurozone overnight index swaps (OIS) show just a 30% probability of a 10 basis point lift in the European Central Bank (ECB) deposit rate by year end to -0.30%.”

Haddad says that interest rate expectations from the ECB “can adjust higher sooner because leading indicators are consistent with firmer Eurozone GDP growth and accelerating inflation”.

Further aiding other major currencies, Haddad also says that sychrnoised and strengthing global growth should also act to support cyclical currencies such as the Australian, New Zealand and Canadian dollar’s.

“The global economy is experiencing its first synchronised expansion since 2007,” he says.

“[This] chart shows that the USD tends to underperform when global growth is improving. Stronger global growth will support commodity prices which bodes well for AUD, NZD and CAD.”

As for the risks to his downbeat view on the dollar, Haddad says they come from a sharp increase in financial market volatility or significantly faster tightening cycle from the Fed.

“A faster pace of Fed funds rate hikes and/or a pick-up in financial market volatility are upside risks to our bearish USD view,” he says.

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