- As US growth peaks, economic conditions becoming more supportive for USD
- Steepening base effects set to weigh on both US growth and inflation outlook
- Sentiment and trend-based indicators suggest continued dollar strength
In our last commentary on the US dollar, we wrote that the buck was set to move higher given underlying economic trends. Specifically, US growth and inflation was likely to keep accelerating, while the opposite was likely to happen in most major regions outside the United States. Following the publication of our last commentary, the US dollar index has strengthened from around 91.80 to around 95.20 today.
While economic trends are now changing, the US dollar is likely to keep strengthening. Going forward, we forecast a further slowdown in global growth and also expect US growth to begin decelerating in rate-of-change terms. Despite significant changes in the underlying landscape, the US dollar rally is just getting started.
The economic growth party is coming to an end
Following two years of accelerating GDP growth (the longest expansion in recent US history), the future outlook for US growth has darkened considerably. Specifically, growth is set to be weighed down by steepening base effects. That is, relatively high growth at this point last year makes year-over-year growth mathematically more difficult going forward. This is shown visually below:
Visualized: steepening base effects
As can be seen above, year-over-year growth in the second half of 2018 will have to contend with relatively high growth rates in the second half of 2017. Beyond base effects, forward-looking economic indicators have also deteriorated in recent history. Recent economic data (e.g. ISM sentiment figures, retail sales, industrial production, etc.) have all softened over the past few weeks. Thanks to weakness in recent data combined with steepening base effects, year-over-year growth is more likely to slow in the near future.
Inflation outlook also darkening
As the outlook for growth darkens, the outlook for inflation is remarkably similar. The two factors weighing on the inflation outlook include (1) slowing commodity price growth and (2) steepening base effects. This is shown below:
Math also weighing on inflation
As can be seen above, crude oil prices are a reliable front-runner for changes in inflation. This is because crude oil is a key input cost across a wide variety of products and services. As crude oil strengthens, prices tend to rise more broadly (stoking inflation). The opposite is true when crude oil prices fall.
Beyond decelerating growth in crude oil prices, upcoming inflation figures are also set to be weighed down by steepening base effects. As can be seen in the graph above, US inflation turned a corner in the second half of 2017. Accordingly, inflation figures for the second half of 2018 will have to overcome both high inflation historically as well as slowing growth in crude oil prices.
As a safe haven currency, the US dollar loves downturns
As economic conditions change, many are calling for the US dollar rally to end. The narrative driving the buck today is based on diverging rate hike expectations. As the US Federal Reserve contends with accelerating growth, inflation and wage costs, the institution is expected to keep hiking rates. On the other hand, other central banks such as the European Central Bank, the Bank of Japan and the Reserve Bank of Australia are unable to hike rates as both growth and inflation are decelerating in most major regions outside the United States. Given the growing divergence between the US and other parts of the world, the US dollar is rallying accordingly.
While economic conditions are indeed changing, slowing growth and inflation (that is, economic downturns) have historically been the best economic environment for the dollar. This is because the US dollar is the world’s reserve currency. As we explained in a previous commentary on the international US dollar lending market (or the “Eurodollar” market), the buck shines during global downturns as foreign borrowers struggle to repay their outstanding US dollar loans. As borrowers dump assets in order to settle US dollar liabilities, the dollar surges accordingly. This dynamic was last seen during the emerging markets downturn starting in 2014 (emerging market businesses and governments are significant borrowers in the Eurodollar market) and also in the 2007-2008 global financial crisis.
Investor sentiment also points to continued strength
Beyond changes in the broader economic environment, indicators relating to investor sentiment also point to continued strength. Specifically, speculator sentiment is not yet excessive by historical standards. A historical overview of speculator positioning in currency futures and options is shown below for reference:
Speculator positioning in the US dollar can go much higher
As can be seen above, speculators have amassed 400,000+ futures and options contracts betting on US dollar strength during recent bull markets (early 2015). As a proportion of total open interest, speculator positions have peaked at around 30%. Today, our implied measure of US dollar speculator positioning shows that speculators are long the dollar to the tune of about 230,000 contracts. As a proportion of total open interest, today’s position is just 16% of the open interest. Given the upcoming economic trends that will help the US dollar strengthen further, our view is that the rally is just getting started.
Beyond speculative positioning, the dollar is also benefiting from a strong trend that is likely to keep propelling the currency higher. This is shown below:
Bullish trend looks set to continue
As can be seen above, the US dollar index is now trading at highs last seen in late 2017. Beyond a clearly bullish price-based trend starting in the second quarter of 2018, recent strength in the US dollar has also been accompanied by relatively high trading volumes. This is a sign that traders are buying the dollar with conviction, a bullish signal for the underlying trend.
All signs point to a stronger dollar
Between slowing growth and inflation, room for speculators to add to long US dollar positions, and a strong bullish trend based on quantitative factors, the US dollar rally is set to continue. While naysayers are correct to point out that today’s underlying economic conditions are set to change, the caveat is that upcoming economic conditions have historically been the best possible environment for the US dollar.