US Dollar Outlook Looks Bright Yet Uncertainty Still Looms

 



Written by: Ahmad Mamdouh, Analyst at ICN.com

This year can be called the year of “stimulus taper” as the Federal Reserve outlined a timetable to roll back its monetary bazooka, which means policymakers believe the world’s biggest economy is capable of recovering without monetary intervention.

The Fed started to scale back bond purchases from January, where it has cut, so far, $40 billion to bring the total to $45 billion.

Theoretically speaking, such monetary action by the Fed should help the dollar to gain strength as it will avoid oversupply in markets after years of ultra-loose money printing.

Hence, the long-term outlook is actually in favor of the aforesaid claim, but it has to be taken into consideration the other surrounding factors that may weigh on the green currency’s prospect.

The dollar has lost near one percent this year, which means it did not benefit from the Fed’s monetary tightening. Perhaps the main reason is the state of uncertainty that dominated investors’ vibes with the beginning of the taper process, especially after a parade of data showing deterioration in economic growth and labor market conditions.

But recently, the data has showed some signs of progress after analysts had blamed the setback in growth pace to the harsh winter weather that took a toll on U.S. businesses and dampened consumers spending in the first quarter.

Improving US Outlook 

The improvement in economic outlook along with the insistence of policymakers to end its bond-buying program by the end of this year has raised speculations the Fed may raise interest rates earlier than anticipated.

If so, the dollar could appreciate against major currencies in the coming period, given the size of the U.S. economy and its impact on global growth.

Fed Chairman Janet Yellen has said the central bank would be delivering policy stimulus for some time to come, where the timing of raising interest rates would depend on the progress in the labor market and inflation.

Unemployment rate held steady at 6.7 percent in March, below the Fed threshold of 6.5 percent, while American employers added 192,000 jobs after a 188,000 gain in February.

Consumer prices firmed a bit in March where the annual reading edged up 1.5 percent from a 1.1 percent rise in February, reminding that the Fed targets 2 percent inflation rate. Analysts predict a drift back toward the target this year.

Eyes will remain on the latest development in U.S. economy data, where further progress along with the Fed’s stimulus withdrawal plan would help the dollar to appreciate against majors over the coming months.

The U.S. is expected to grow 2.8% this year, despite a slowdown in some emerging economies, the International Monetary Fund said in its latest global outlook.  

Despite the anemic 0.1 percent growth recorded in the first quarter, which is much weaker than anticipations of 1.1 percent, the most recent Fed statement has mentioned "growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions."

A rise in interest rate, however, is not likely to take place any soon, or, in other words, the borrowing cost would remain  near zero "for a considerable time" as the Fed believes that economic indicators were not yet strong enough.  

Other Factors

By using the Latin phrase 'ceteris paribus' that translates approximately to "holding other things constant," the previously mentioned expectations for the dollar are valid.

Nevertheless, the U.S. is not an isolated island and therefore factors may affect the dollar’s outlook, most noticeably over the short term.

China's yuan hit 14-month low versus the green currency on April 22 after the People’s Bank of China guided the yuan weaker to damp speculations of bets on currency appreciation.   

The U.S., however, urged China to allow its renminbi to move according to market forces against its U.S. counterpart, as it aims to give an impetus to the economy through disallowing Chinese exporters to have an edge over U.S. competitors.

The conflict, and volatility, therefore, is predicted to resume between the world’s biggest economies over exchange rate, especially after China has experienced its slowest pace in 18 months in the first three months this year.

While the Fed is on its way to withdraw stimulus completely by the end of the year, both  the European Central Bank and the Bank of Japan have pledged to adopt quantitative easing methods to support growth and avert the looming risk of deflation.

In that scenario, the dollar should strengthen against both euro and yen.

"A strengthening of the exchange rate requires further monetary stimulus. That is an important dimension for our price stability," ECB President Mario Draghi said.

Bank of England has stressed on the risk of the pound’s appreciation as it puts downside pressure on inflation.

“Sterling has appreciated by another 1.5 percent during this month, and it was possible that this gradual appreciations would continue if prospects in the U.K. continued to be seen as increasingly favorable relative to those of it’s main trading partners,” BOE minutes for March said.

Therefore, signs of improvement in other advanced economies, most notably the United Kingdom, along with the uncertainty about the impact of stimulus withdrawal on the U.S. economy may keep some downside pressure on the dollar.  

Carry Trades

Another critical dimension is the recent emergence of the terminology of “carry trades” in markets at which traders buy high-yielding assets using borrowing in currencies with low borrowing cost.

The U.S. dollar has been favorable in the purchase of the Turkish lira, the South African rand, the Brazilian real, the Indonesian rupiah and the Indian rupee, after they all decided to raise their interest rates following the latest emerging market rout.

Accordingly, the euro may join the yen while may replace the dollar as a preferred currency for trades looking for low-cost borrowing.

As a matter of fact, the U.S. could withstand the dollar’s appreciation and may even benefit from it. Why? Consumer spending accounts for nearly 70 percent of gross domestic product and thereby a fall in inflation can trigger further purchases by households, whilst a drop in exports will not have a big impact since the United States does not depend largely on it overseas sales.