Given the huge uncertainty of what Trump wants to do and what he can actually do, it is likely that the Fed will remain sometimes behind and sometimes ahead of the inflation curve. This could prevent any further substantial dollar strength.
Last week, the dollar broke above 1.04 to the euro, the first time it had been so strong since January 2003. In April last year, it had powered up to the 1.05-1.06 range, at which time the markets were abuzz with talk about euro parity. Since then, it has bounced around between 1.05 and 1.15 before last week’s breakthrough.
Interestingly, at this time, there is very little talk about the dollar blowing through euro parity. This despite the near-certainty of more Fed rate hikes, the widely expected expansionary fiscal policy under Trump which is expected to make investment in the US more attractive, and continuing political concerns in Europe.
Could it be that markets are planning something else?
It is important to recognise that markets do not always follow the obvious. Higher interest rates will not necessarily lead to a stronger currency, particularly if there is a threat of even higher inflation. And, given the huge uncertainty of what US president Donald Trump wants to do and what he can actually do, it is likely that the Fed will remain sometimes behind and sometimes ahead of the inflation curve. This uncertainty could prevent any further substantial dollar strength.
US stock markets have been on a wild tear ever since Trump won the election—the Dow has put on nearly 10% and is flirting with the loud 20,000 level. It is hard to believe that it won’t break higher, but it is equally hard to believe that this will be sustainable. Sure, the new government will cut corporate taxes significantly and, in parallel, ramp up spending to build walls and create jobs; the problem is all of this will be hugely inflationary first before it delivers on the promised growth.
Again, if the dollar were to strengthen further, Trump’s demand that other countries stop selling “unfairly” to America will be very difficult to implement. Already some key currencies—the Mexican peso, for instance—are so weak that their economies are hugely competitive. Europe is showing some signs of economic life and with the euro at almost parity, selling into America will be easy as cappuccino on Sunday morning.
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In other words, the US trade deficit ain’t going away any time soon, and the market knows it.
Looking at the chart of EUR/USD also suggests that a turnaround is imminent. Since its inception in 1999, the euro has so far run in three cycles. First, right after its birth (at around 1.18), it fell sharply. At that time there was no investment alternative to the dollar—Japan was in the first of its lost decades, the euro was a new and untested entity and gold was flat on its back at around $250 an ounce. The US economy was powering ahead with the dot-com boom, which finally fell apart, unravelling between March 2000 and October 2002. The NASDAQ crashed losing 78% of its value and the Fed slashed interest rates.
The dollar turned right after—in January 2003, at which time the euro was worth just 82 US cents. EUR/USD became very volatile and the dollar began to fall sharply. It reached 1.35 to the Euro—a drop of nearly 40%—in two years. It continued to fall after that and finally bottomed out in 2008, when the stock market collapsed under the weight of the mortgage crisis. At its trough, it took nearly 1.6 dollars to buy one Euro.
Once again the Fed, this time under Ben Bernanke, slashed rates and took monetary easing to a new plane. This time, however, the dollar started to strengthen. The move was not unequivocal—markets remained volatile, driven by the European sovereign debt crisis, Greece, immigrants and a rising unease on the continent. But, by early 2015, as we have seen, the dollar had risen to 1.05 to the Euro.
Turning to Saint Fibonnaci, who originally linked market movements to natural phenomena, the dollar’s rise against the Euro (from 1.60 to 1.05 between 2008 and 2015) has retraced almost exactly 68% of its fall (from 0.82 to 1.60 between 2003 and 2008). This in technical analysis defines a potential major turning point.
The other two criteria needed to confirm a turnaround also appear to be in place.
The first is a sharp increase in volatility—EUR/USD volatility, which had fallen to an all-time low of below 5% in 2013 doubled to over 10% in a year.
The second is some kind of paradigm shift, usually accompanied by a crash in markets. Trump’s election certainly represents a paradigm shift—his much-touted plan to cut corporate taxes to 15% should dramatically increase the attractiveness of investment in the US. Whether it also triggers another huge collapse in US equities—perhaps, driven by uncertainties on global trade—remains to be seen.
A turning point for the dollar is on the cards.
The author is CEO, Mecklai Financial