Dollar Prospects: Limited downside

In order for the US Dollar to weaken in an economic environment of incipient economic turmoil it requires a specific but narrow set of circumstances. 

The US economy must lose enough headway so that the Fed governors feel obliged to take out an insurance policy. If the US signs of decline are few then the global environment needs to be threatening or there may be specific circumstances that could develop into a major problem for the American economy.

If the domestic economy slows first or weaker growth is imported from abroad, its effect for Fed policy is the same.

However, the conditions in the US or overseas cannot grow into a crisis like the financial meltdown a decade ago or any one of a number of lesser situations since because in times of trouble the safe haven of choice for global markets remains the US Dollar and US assets.  

We are in one of those interim periods now.  The dollar has fallen but the global economy and the US is still muddling along. There is no crisis or recession yet. 

The Dollar Index has lost 2.2% since May 29^th but it is far from losing the range of the last 18 months.

US growth was 3.1% annualized in the first quarter and seems to have slowed considerably in the second with the Atlanta Fed GDPNow model estimating just 1.5% on June 28^th. The world economy is also stuttering. The IMF estimate for global GDP in 2019 has fallen from 3.7% last October to 3.5% in January and 3.3% in April.

There are several reasons for the dollar’s weakness beginning with the Fed’s dovish meeting this month and the market conviction that there will be at least a 0.25% cut at the end of July.  

Treasury rates have been falling since last November, even before the last Fed rate hike in December.  Perhaps President Trump’s forceful suggestions for a rate cut and lower dollar are having an effect at the margin but the credit markets had decided that a rate cut was next half a year ago.

The Fed policy shift is new, and that is the why it has damaged the dollar. The FOMC had been the only major central bank raising rates and until this year had provided few hints about where the tightening cycle might end.

The US economy is probably better insulated than most major industrialized economies because its GDP is less dependent on exports than others but it is not separate and the Fed does not view it so.

The greater worries are still on the horizon.  The equity markets have been studiously avoiding pricing the conclusion of a full-fledged trade war between the US and China.  

Presidents Xi and Trump will meet in Japan and the most likely outcome is another trade truce, but a complete breakdown or a comprehensive agreement are not out of the question.  But whatever the outcome it will shortly end the dollar slough.

If a comprehensive agreement is signed that would remove the Fed’s major external concern. The likely US economic response would end the central bank’s angst over fading US growth and soon put paid to the easing policy. Even a return to neutral, which would be the first Fed change, would send the dollar higher.

The euro in contrast would remain saddled with the problem of Brexit, an inherently slower economy and a slew of political problems in Italy, France and Eastern Europe. The ECB’s rate policy since the financial crisis is not an expression of confidence in either the economic or political potential of the European Union.

If there is a total estrangement between the US and China followed by rounds of competing and escalating tariffs the impact on global markets, on business and consumer confidence would likely precipitate a recession.

The Fed would join the global plunge to lower rates.  But through the cycle and at the end US rates would be higher than all of the dollar’s major competitors. The amount of fear generated by a complete trade breakdown between the world’s two largest economies, its unknown severity and duration would send market fleeing to the safety of US assets and the dollar.

The middle course of a new truce and resumed negotiations though less fearful will also end up aiding the dollar.

The Reserve Bank of Australia and the Reserve Bank of New Zealand have begun to cut rates. Mario Draghi of the ECB has said that he stands ready to do the same, though in his case it probably means more continental bond purchases since the main refinance rate is at zero.   

The logic of the banks will be economic not currency, but the result will be an environment of falling rates. The US will likely have the highest rates, the best economy and by virtue the strongest currency.

The longer the cold trade war between the US and China goes on the stronger will be the market temptation to seek safety, and that too, means the US Dollar.