The big news dominating financial markets during the past 4-5 months has been the strength of the U.S. Dollar against most world currencies. The Dollar Index has risen 25 % since late June 2014. Here is a look at the U.S. Dollar against the Euro currency, as the Euro is the main component of the Dollar Index, comprising 57.6 % of the weighting.
In past years, before the euro came into being, each of the various countries now comprising the euro saw smaller weighting against the US Dollar, which explains the heavy euro weighting now. Others in the group are the Japanese Yen, with a 13.6 % weight, the Pound at 11.9 %, the Canadian Dollar 9.1%, Swedish Krona at 4.2 % and the Swiss Franc rounding out the index at 3.6 %.
Back Story
During the U.S. Quantitative Easing (QE) period, while the Federal Reserve Board pumped trillions into the U.S. economy through bond purchases in an effort to stimulate growth, the Dollar was pushed to multi-year lows at 72.00. At this same time, interest rates were gradually reduced to virtually zero, adding to the substantial dollar fall. This program was an effort to mimic the lengthy and mostly unsuccessful QE policy instituted by Japan during the late 1990s and early 2000s.
U.S. and Japanese QE did nothing to actually improve the respective economies, but it accomplished the main purpose, which was to keep stock indices moving higher. The dollar began to rise as QE was cut back and officially ended last October. The Fed was very slow and deliberate in their cutbacks, as stock indices roiled at the mere mention of cutting QE. The balancing act continues to this day, as now any mention of raising rates is met with stock market weakness. As the US Dollar strengthens, it has a negative effect on U.S. multinational companies, so the Fed has been trotting out one Fed governor after another in an effort to disparage the dollar by continuing to stall any rate hike talk. This has a double calming effect as, for a short time at least, the stock market rises and the dollar falters.
After the long climb which pushed the US Dollar past the psychological 100.00 level, many are intimating that the dollar move is over, and it will now pull back substantially since the Fed continues to stall any rate hikes while citing low inflation as the reason for extreme patience. The reality is that the Fed is terrified that any rate hike might induce the first significant stock indices correction in nearly five years. This is a legitimate concern, and one must look past the dollar acceleration to understand why.
During the strong US Dollar phase seen during the Reagan, Clinton, and George W. Bush years, the rising dollar was due to actual strong economic factors, such as strong job growth, and much higher interest rates. Rates were raised then to slow down strong economic growth, to hold inflation in check, and the US Dollar’s rise normal and connected to appropriate economic factors.
The Current Move
The current move however is much different in that we have seen slow worldwide growth. U.S. job creation has been confusing with on the surface improvement of jobs created while commensurate wage pressure is nonexistent. Additionally economic growth as evidenced by the anemic GDP numbers is sorely lacking. In effect, it isn’t so much that the U.S. Dollar is overly powerful, but it is “the best of the least” right now. We saw our market crash first and were the first to initiate the QE program, which was so difficult to exit. Europe just began their version of QE, and, much like government social programs, no one wants to give up their freebies. And make no mistake, QE was a freebie for large banks, large stock market investors, and large corporations.
So the question now is where do the US Dollar and euro go from here? The Dollar was overdone on the upside after the long rise from 72.00 to 100.00 and the Euro overdone on the downside, after the long fall from 160.00 to 105.00 as the Dollar rose. I would expect a short-term period of perhaps a month or slightly more where each market consolidates into a trading range at these new levels.
I expect the dollar to trade between 95.00 and 100.00 during this phase, while the euro most likely vacillates between recent lows at 105.00 and the lower breakdown point near 111.00. The bottom line however is this: The Fed can only keep the dollar down for so long with mere words alone.
I believe that they are stalling to try to give Europe a chance to catch up in the QE cycle so the blow will be minimized when we actually begin to raise rates. They seem to be forgetting that our QE lasted four years and Europe has just begun.
Mario Draghi wants a weak currency also, as Japan did in the 90s, in order to at least keep their economies limping along with the stronger exports that a weak currency can bring. Europe is actually experiencing negative interest rate yields and they must exit QE first before even considering raising rates there.
Conclusion
As mentioned earlier, however it took the U.S. four years to finally phase out QE and Europe will go through the same pain as it tries to employ an exit strategy. As with most things in life, both in general and with market conditions specifically, past results are not indicative of future results, but, in this case, they can potentially be a strong indicator of future activity.
After the consolidation period, I expect the dollar to resume its uptrend and the euro its downtrend going forward. I expect a minimum 105.00 dollar by year end, up to 110.00-115.00 by mid-2016. At the same time, I look for the euro to see at least 95.00 by year end and 85.00-90.00 by mid-2016.
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Bill Frejlich and John McGuire are account executives at The Price Futures Group. For a more in depth analysis and trading strategies from them that can help you exploit opportunities like this, please click here.
