What to Make of the USD Weakness

Trading Discussion Currencies
1

Partly due to will-this-ever-end White House political circus, the U.S. dollar is weakening like my knees whenever I see Justin Bieber. Here’s my take:

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  • Confidence surveys (e.g., NFIB, U of Mich) are down only slightly from elevated levels.
  • A stronger dollar would indicate that the Fed is getting ahead of the curve. Since this isn’t the case, the FOMC still has room to raise rates. Which they’ll probably wait until December to do. Dollar will strengthen like when Superman feels the sun if the Fed follows their dot-plot forecasts.
  • I still expect a pro-growth US tax bill to pass despite the healthcare reform attempt failing.
  • A weak dollar should benefit the US and emerging markets (EM). A stronger dollar benefits EU and Japan. EM growth is picking up so I see faster global growth for now which should help corporate earnings.
  • Historically, a weak dollar means higher commodity prices, which sucks for the consumer. But with oil prices declining, due to oversupply factors (e.g. fracking, Libya/Nigeria production, etc.), this historical relationship isn’t happening.
  • Low oil prices + US at full employment. Wages are rising (slowly) and trending upward. US ain’t looking so bad at the moment.

Bottom Line: Business cycles do not end with corporate profits up AND wages up together. The weaker dollar supports profits. Commodity prices are in check. And full employment in the US supports wage gains. We’re in the Goldilocks…not-too-hot-not-too-cold mode.

2

Here’s another reason to expect the USD to continue to fall…

The USD is weak again today and plunging lows not seen for 15 months. The “obvious” reasons for the USD weakness include converging foreign economic activity, more hawkish foreign monetary policies, and a general overvaluation of USD.

Yet, another less obvious catalyst for USD weakness is taking shape right here at home: the ballooning US government budget deficit.

The Congressional Budget Office (CBO) released in June new estimates for GDP and the budget balance through 2027. The estimates were based on current law, meaning that health care and tax reform were not considered.

With health care reform all but dead as of today, a big variable is removed from the equation. Taxes are still a bogie and may or may not increase the budget deficit (tax reform as it’s being proposed is unlikely to reduce it).

But, the main takeaway from the estimates is that the budget deficit is on track to increase to 5.2% of GDP over the next ten years compared to about 3.4% today. Importantly, the CBO does not forecast recessions and we are eight years into this expansion, making it one of the longest in US history.

A recession would be accompanied by fiscal policy expansion, not contraction, and thus would necessarily increase the budget deficit relative to current projections.

So why all this talk about the budget deficit?

The US fiscal position is highly correlated to the level of the US dollar index. If history is a guide, an expanding budget deficit would likely be accompanied by a falling USD.

In the chart below we plot the US budget deficit/surplus (blue area, left axis, inverted) against the USD spot index (red line, right axis, inverted). Over long periods of time this relationship holds quite closely.

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3

The Dollar Index may just continue dropping in the longer term, but for now the 200 week EMA aroudn the 94.00 level may act as support. There could be a profit taking pullback but the bearish trend is still in place.