With all the changes occurring in markets, it can be challenging to find an objective way to assess US Dollar valuations. Here are three compelling arguments which may suggest the Dollar has reached its pinnacle:
When the Fed signalled it would begin raising interest rates at the end of 2015, as you would expect, the Dollar appreciated. The global boom properly took hold in 2017, which prompted an outflow from the Dollar into riskier assets, despite continued interest rate hikes. This year, we are seeing this phenomenon reverse. Declining growth prospects are pushing the Dollar higher, while the Fed begins to commit to interest rate cuts. Perhaps in a similar fashion to 2017, the global economic backdrop is the overarching force driving valuation. But this reversal assumes global growth will continue to decelerate, which could be unlikely.
Another measure is the so-called twin deficit—a combination of the government spending deficit and trade deficit. Together, they have reliably foreshadowed the movement of a trade-weighted US Dollar Index. Typically, a widening of both deficits (suggesting too-much-borrowing and overvaluation) is followed by a depreciating Dollar. As the chart shows, the twin deficit has been gradually widening (blue line lower) since 2015, signalling a gradual decline in the Dollar may follow. It’s important to note that this is a more reliable predictor when there is a sharp change in deficits, but that is not the case now.
You need only look at recent headlines to understand that currency valuations and trade are the current hot button issue in contemporary political discourse (or Tweet). While developed market central banks firmly hold the reins to the rate and liquidity bandwagon, the government via the Treasury can take independent action to devalue the US Dollar. The US has previously intervened in currency markets, although this was a coordinated effort with other central banks to maintain stable exchange rates. Direct political currency manipulation would be unprecedented for the US, but you cannot discount the probability of any event too much when Donald Trump is President.
Politics, particularly since Donald Trump took office, have become much more unpredictable. Trump’s penchant for breaking norms and a simplistic view of trade make the political angle entirely possible. It is also likely to cause the more severe change in valuation of the three arguments, were it to occur. The global growth argument is perhaps the most compelling since it describes a well understood, if underappreciated, market dynamic. The challenge there is guessing the trajectory of global growth; who has their crystal ball at hand?
The announcement of a new British Prime Minister on Tuesday and the potential for resignations from key Ministers will be the key driving force of Sterling this week. UK data is light.
This week is the calm before the storm for the Federal Reserve ahead of July’s monetary policy meeting next week. There are a couple of data points to watch, which could drive the Dollar in the short-term.
This could be a crucial week for the Euro as the European Central Bank (ECB) could change its main policy rate on Thursday. What’s more, Purchasing Managers’ Index (PMI) figures from Europe’s major economies will provide a leading health check on the Eurozone.