Dollar 'should' recover by another 20-30% at a minimum

Outlook:

We thought we smelled a dollar recovery on the way but thought it would be due to a reaction against the overreaction to Trump's many failures. We did get some of that, with talk about tax reform bubbling up to the surface. But we must be watching too much cable TV news, with its emphasis on Russia-related scandals and whether there is a cover-up going on. In the end, it was not a Trump-related set of factors that formed the dollar rally trigger.

Instead of a single factor breathing new life into risk appetite, we got five of them all on one day. Untangling which ones influenced the others is not a useful exercise. What is a useful observation is that it takes a set of factors to change sentiment about the dollar, whereas traders will settle for one or two in other currencies.

The dollar benefited from a quintuple play—good economic data (Conference Board consumer confidence), less pessimism about Trump never getting anything done, a rise in the 2-year and 10-year yield and a rise in the CME Fed funds futures probability of a June hike from 48.3% early in the day to 53% near the close. The fifth factor was the deeply oversold condition of the dollar against most of the majors on the chart.

It's likely the first four factors might not have done the trick if the dollar had not been so oversold in the first place. It's also a lesson in the weakness of indicators showing overbought/oversold, of which the stochastic oscillator is the prime example. Being oversold alone doesn't drive a correction.

The WSJ claims it was the good economic data that drove the dollar up. This is probably fair, but the story really should include yields as the intervening factor. Good data alone that doesn't drive yields doesn't drive the dollar, as we saw with the lack of boost from durables last Friday.

And while the Fed is not getting any credit, the CME probability of a June hike rose from 48.3% to 53% over the course of a single day. This morning the numbers are 50.7% from 46.6%. Weirdly, of the three Fed speakers yesterday, only Fischer said anything that could inspire such a move. He said two more hikes this year ‘seems about right," hardly a ringing endorsement. Yellen didn't mention the next hike and blathered on about employment, while Dallas Fed Pres Kaplan poisoned the atmosphere with the word "gradual." Overnight we got a comment from Fed Gov Powell that the Fed is still in a wait-and-see stance about any new fiscal policies. Worse, the Fed is not trying to imagine what they might be and the balance sheet will be contracted when the Fed is good and ready. There is nothing here to inspire a rise in the probability of a hike. We searched for a reason for the probability to shift and didn't find one. We have two more Feds speaking today.

Something that should be occupying us is the first day of Brexit today at around noon, when the UK's Article 50 letter reaches the European Union president Tusk. Nobody knows what the letter says. The letter kills a relationship that started in 1973. It will take two years to be fully dead and buried. We will get some talk at some point soon about zombies, although it's far from clear that exiting the EU will be so dire. Still, the EU's top Brexit negotiator, Michael Barnier, said "today is day one of a very difficult road" and while the EU wants a fair deal, any deal for the UK will be "inferior to membership." It falls to Malta, the current EU president, to deliver the EU guidelines to PM May (within 48 hours). There's a hint right there—the EU is writing the guidelines.

Bloomberg reports that a UK law firm has identified 339 negotiating points. Inability for each side to understand the other could conceivably end up with the UK just exiting with no deal at all, leaving "the U.K. and the other nations of Europe embittered and resentful for a generation." But so far it looks like everyone feels conciliatory, except maybe Merkel, who wants those EU bills to get paid. Bloomberg reports Capital Economics opines "If May's missive "contains conciliatory language, and this is echoed in the response from the EU, then hard Brexit worries could certainly dissipate somewhat further." Bloomberg also reports "Strategists at Barclays see the pound rising to $1.32 by the end of 2017 as the outcome of Brexit ‘is probably not going to be as bad' as anticipated. Those at UBS reckon a return to $1.36 is possible if the talks prove ‘broadly constructive and collaborative.'"

Dream on. PM May has said "no deal is better than a bad deal for Britain."

Martin Wolf in the FT writes that Brexit is a tragedy. "The UK will be poorer, more divided and less influential. Brexiters will deny all this. They are wrong. The evidence on modern trade is clear: distance is of enormous importance. The supply chains that link physical goods and services together work best over short distances. The models on which Brexiters rely ignore this reality. This is also why the creation of the single market required substantial regulatory harmonisation, which allows relatively frictionless cross-border trade.... Brexiters will also learn that geography is political destiny. The UK can never be a non-European country. It will always be intimately affected by developments on the continent. But now, faced with a threatening Russia, an indifferent US, a chaotic Middle East, a rising China and the global threats of climate change, it is removing its voice from the system that organizes its continent. The UK is no longer in the 19th century. It is in the 21st. Isolation will not be splendid — it will be isolation."

We may be able to see whether Brexit will be hard or soft depending on what the May letter to Tusk says and its tone, and then the response from the EU. Nobody has said when the public ever gets to see these two letters, if we get to see them at all. If we do get them, the parsing of each word will be every bit as delicate as those of the Fed minutes. We wouldn't count on a tone that is "broadly constructive and collaborative." Sterling is at risk.

As for the dollar, we see the dollar rally wobbling today near that support line as traders digest whether they are buying the down move is over. Then the dollar "should" recover by another 20-30% at a minimum, perhaps more. But that forecast depends on nothing bad coming along and on the bond market continuing to capitulate to the idea of a June rate hike.