2016 Market Preview: U.S. Dollar, China And Oil – Part II

<< Read More: 2016 Market Preview – Part I

This is the second of three parts of the 2016 preview that appeared in HRA Journal Issue 245-246.This part deals with the outlook for the US Dollar, China and oil.The final section, dealing with several metals, will be issued shortly.

The $US: Still Tilting at the Windmill

Yes folks, it’s lonely in dollar bear land. I know there are others talking about “dollar collapse” but I’m not part of the perma-bear crowd that expects the global fiat currency regime to collapse. My views are more mundane and (I like to think) fact based. 

I don’t expect the greenback to fall apart but I do think it’s topping.I don’t view this as something apocalyptic. On the contrary, reversing the upward trajectory of the USD will be good for everyone, including (perhaps especially) the US itself. The fact it would take a lot of pressure off commodities in general is a nice bonus.

The main reason the USD is expected to continue strengthening is widening interest rate differentials between the US and everyone else.If we accept the Fed’s comments and dot plots at face value we could expect four to six rate increases by the middle of next year. 

The chart above shows the recent history of rate increases (colored lines) since the great recession. The grey lines trace later rate cuts as central bank after central bank backed off and lowered rates back towards, and in some cases below, zero.

I think the Fed is the least likely to reverse course but it’s equally unlikely it will raise rates more than a couple of times this year. We just had the first FOMC meeting since the rate increase and there was plenty of discussion about offshore risks and little wording that indicates its full steam ahead for rate increases.

Traders were disappointed with the meeting statement but it was about what I expected. There was never a chance of the Fed cutting rates this soon. What little credibility it has would be destroyed by that move.It does make the weak set of rate increases – one or perhaps two this year as implied by Fed funds futures—look much more likely. 

If that is the outcome it won’t shock bond traders. The chart of the 2 year Treasury yield on this page makes their opinion clear. After the Fed rate increase the yield rose briefly then fell by over 0.4% since the start of 2016.So much for the Fed guiding rates higher.

Some of this is driven by oil prices that factor into inflation expectations. Those continue to fall along with market indices and commodity prices.I found it mind boggling to hear a couple of Fed governors wonder out loud if they might have underestimated the length, depth and impact of lower oil prices before the Fed meeting.Seriously?!

As the introductory editorial makes clear my base case for this year is a mild recession for the US and it may in fact be a couple of individual quarters of sub-zero growth that never gets officially classified as one. 

This scenario means the growth differential between the US and the EU and Japan would be smaller than most currently assume.Real—inflation adjusted- growth rates are trickier but here too the spread may be much narrower. 

Ironically it would not be narrower for “good” reasons.It seems highly likely both Japan and the EU will be suffering under deflation through the rest of this year, especially if oil prices don’t recover.If you have deflation it’s added to the nominal growth rate (i.e.—a one percent nominal growth rate with one percent deflation yields a two percent real growth rate).The math is about to get funny.

Both the ECB and the BoJ are fighting deflation (they apparently noticed it before the Fed).As this piece was being edited the BoJ announced it was moving to negative interest rates, charging banks 10 basis points for excess reserves on deposit.It joins three Euro area countries and the ECB itself that already have negative rates. One third of the bonds in Europe carry negative rates now, mostly at the short end of the curve. Monetary purists are horrified by the concept.

The US Fed wants to “normalize” rates but it’s tougher to do with other central banks cutting theirs. Janet Yellen and Company are not fools.They are well aware of the impact of a surging USD as much as they try to underplay it in news conferences.If Yellen could think of a way to jawbone the Dollar lower she would be doing it.

Do moves by other central banks make it tougher for the USD to complete topping process? Obviously yes, though increasing deflation in those areas will mute the impact of their rate cuts.