Since the end of last week, we have seen the narrative that decelerating (rather than fading) economic momentum at this stage in the US has, and may well continue to lean on the USD in the near term. Something we have been keen to stress in the last month or so is the combined effect of a tightening Fed and a stronger USD, which then start to prove restrictive – or less accommodative as the Fed would put it. It’s not rocket science, but we have seen this time and again. As a function of the market overextending fundamental themes, we have therefore reached a point where the Fed now have to actively consider whether maintaining their current rate profile is ‘prudent’ – a term used by Harker last week.
Even so, the USD rally is not all about yield differentials, though naturally they come into play and provide an added draw for the greenback. With little appetite to carry risk elsewhere, it’s default status is as strong as it has ever been. Europe – or rather the EU – is doing little to soothe investor concerns with its disapproval of the Italian budget, while trade tensions have been hurting all major exporting regions. It is pretty clear what is hampering GBP at the moment, so we won’t go there! Asia’s current malaise is clouded by worries over a potential slowdown in China, exacerbated by worries over private debt, though with focus on the impact of US tariffs. There are signs that this is also feeding into the US manufacturing sector, as highlighted by the ISM surveys. For now, we will concede that protectionist measures are effectively a lose-lose situation, yet with the ultimate loser being the consumer, it stands to reason, that domestically generated growth (rather than export-focused) based economies will eventually suffer also. We need to listen to some of the doomsday scenarios on UK inflation should we settle on WTO rules!
Yesterday’s NAHB house price index also raised some eyebrows as we saw a drop from 68 to 60, so with the US being far from immune to personal debt dynamics, we expect to see a challenge – to some degree – of the USD as the out and out safe haven. Liquidity is a huge draw, but there is room for some differentiation here and the resilience in Gold price leads me to believe that we could start to see this gain traction soon.
Adding to this view is the all too modest pullback in USD/JPY. It’s equal resilience to the downside has also endorsed the USD in times of flight to safety, coerced by the BoJ’s insistence that it will keep printing JPY in order to get inflation moving. It’s not working – and why would it when we continue to see the divestment mill pushing funds into higher yielding overseas vehicles, and in its obedience, the market seems to be more inclined to tow the central bank line.
In conclusion, the signs are there that the USD seems unlikely to give up any material ground just yet – USD/JPY is telling us that. For the EUR to gain any serious traction back towards longer-term fair value will require the EU to try and calm matters with Italy. Red lines are all over the place, however, as we have seen in the Brexit saga, so political ideology (intransigence) continues to weigh on sentiment. Even so, just as we saw the market trying to squeeze blood out of a stone at 1.2500 earlier in the year, we may well be seeing the same ‘destructive’ pattern in ignoring current valuation levels in the USD. Volatility can be a positive ‘pressure valve’ (if you like), in smoothing out exchange rate averages over time.