USD is lower despite the yield spread against other majors higher and rising

Outlook:

The dollar is lower despite the yield spread against other majors higher and rising. The basic understanding of FX determination would have the dollar higher.  What’s going on? 

One excuse might be that the Fed hike next week and even the one in December are fully priced in and not a ruling factor anymore. Besides, who knows what happens next year? The deflationary effects of the trade war could jump up and overwhelm the inflationary effects, and the Fed would have to retreat.

Another big, fat dollar negative is the deficit, now over 100% of GDP and rising. The Treasury has to issue increasingly higher amounts of bills, notes and bonds to fund the deficit, flooding the market with supply (prices down, yields up). The Fed is about to raise the amount it feeds back into the market, too. We find that FX traders are unmoved by the Reinhart and Rogoff argument that deficits this big historically lead to various failures, including currency devaluation. We have known about the 100% thing for over a year. Why would it kick in just now? The dollar barely burps when the idiots in Congress shut down the government. Maybe it’s because the US is a special case because of the US’ position in world affairs, including being the issuer of the trade numeraire and the world’s top reserve currency.

So, if traders are dumping dollars/paring ling positions, what is their thinking? First there is the too-far, too-fast argument. The dollar index fell from 102.95 in Jan 2017 to 90.57 in Jan 2018 or 12.4 points, but recovered almost half of it, 5.8 points, in the 7+ months to 96.36 by Aug 5. Is that too far, too fast? Traders don’t generally look at things in this manner and don’t keep score by year. An unwillingness to return to the Jan 2017 level, when the tax cut was still ahead of us, might be meaningful. Traders like to anticipate and to trade on the rumor.

If the tax cut was the big event driving the dollar up, maybe its effect has faded now that other events are intervening, especially the trade war. Maybe the trade war is going to be recessionary and possibly deflationary in the end, meaning next year, hobbling the Fed’s 2019 hiking plans. If you are positioning that far ahead, you are a dollar seller. We doubt the majority big bank traders are thinking like this. Some big sovereign wealth funds or other long-term thinking managers, maybe.

Another idea is that the “cycle” is in a late stage and far too bubbly. Equities are ridiculously high. Confidence is unsustainably high. We are due for a fall. Funny enough, we can easily build a positive scenario out of this: the trade war is going to dampen over-confidence and put the brakes on at least some of the bubbly asset prices—prolonging this high stage of the cycle.

We might say the dollar is on the defensive now as a temporary case of confusion over an unprecedented set of conditions that are disrupting the normal “cycle” and can end up prolonging it for far longer than history would suggest. We are putting the word “cycle” in quote marks because while there are several cycles that can be demonstrated, nobody ever knows which one is at work at any one time.

By some reckonings, the stock market rally “should” be ending any day now. This doesn’t necessarily have any effect on the dollar, which is remarkably independent of equity pricing, unless and until a flight out of equities starts hitting the fixed income markets, driving prices up from excess demand and thus yields down. The dollar “should” fall on falling yields and yield differentials, assuming other majors don’t get the same effect and thus a one-for-one drop in yields.

But this story falls apart when you consider supply is on the rise, too, as the US government issues more and more to fund the deficit and the Fed releases more and more into the market. An exodus out of equities could end up having no effect at all on fixed income given these countervailing factors.

Forget equities. As noted above, the housing market stall is a key factor for consumer/household confidence. We get fabulous results from wage expectations and JOLTS that show people willing to quit their jobs because they are confident they can get a new one at better pay. But we don’t have an index for confidence the average Joe can sell his house to get a new job in another town or state.

In other words, under the stock market bubble and confidence about wages/after-tax income, there is a tumor of discontent over housing. Another tumor might be developing over the cost of fuel. 

We get the US Sept PM|I for manufacturing, services and the composite later this morning. If recent responses to data are anything to go by, good results will not halt the dollar’s slide. Remember that earlier, soft data (consumer confidence) outgunned hard data. And trade is still on our minds, even if not at screaming anxiety levels. The dollar stopped falling against the CAD yesterday when trade talks were ended with no outcome anyone can find. But the dollar’s gains so far are minor.

Longer run, unless we find out what is causing the current dollar downdraft, the dollar “should” come back on the relative fundamentals. But his is often a forlorn hope rather than reasoned analysis, not least because of the asymmetrical treatment of the dollar (which falls more on bad data than other currencies and rises less on good data than other currencies). Trade the chart, not the data, but keep it short-lived.

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes. To see the full report and the traders’ advisories, sign up for a free trial now!