US dollar policy. It really matters
Comment of the Day

January 30 2018

Commentary by Eoin Treacy

US dollar policy. It really matters

Thanks to a subscriber for this report from Deutsche Bank which may be of interest. Here is a section:

Eoin Treacy's view

Here is a link to the full report and here is a section:

A weak USD will mainly hurt US equities if the inflationary impact undermines bonds. Here the Fed trade model suggests it needs a large 10% TWI decline to add 0.25% - 0.5% to core PCE deflator over a year. While USD weakness has accelerated, it is less obvious that the bear market for bonds is about to immediately accelerate sharply with it, in no small part because inflation pass through is so modest.

Another possible reinforcement to the bond bear scenario is if US/geopolitics generates bond sales, particularly official selling. This is why we are now all on 'China watch'. Mnuchin's comments linking trade to the USD, is not going to be helpful in persuading other countries not to follow course. The one country where retaliation matters in a way that would give US equities second thoughts remains China. So far, China has greeted US actions on trade with barely a blink, but generally has a policy approach of ‘proportionality’ or proportional retaliation. As noted in a recent Alpha Alert piece, China retaliation via Treasury sales would not be a logical proportional response because it hurts China's own interests, and besides, alternative yields in other sovereign G7 liquid markets are minuscule when compared with the US.

Even though the pass through to inflation could be limited, almost all the other US inflationary signals are pointing higher (lagged demand, output gaps, oil/ commodity prices) and the weak USD can only reinforce DB’s call for 4 rate hikes this year, eventually acting as some restraint on USD weakness.

Does this change the directional call for moderate additional USD weakness? No, although it's contingent on China’s response. If China does not up the ante on trade, risk should trade ok, and the USD will trade weaker against most currencies. If China responds in a way that is risk negative, EM will start to get hit, and USD weakness will get concentrated against the G10 majors. All of the above also works with greater vol across all asset classes and currencies.

The Dollar has been trending lower since early 2017 and the pace of the decline picked up pace with the approval of the Trump tax cuts. Since these measures represent procyclical policies which are the equivalent of deficit spending they have had a negative effect on the Dollar while also boosting stocks and commodity prices.

The Chinese have already made rumblings about the sustainability of their Treasury purchases. However, with the Renminbi now accelerating higher, they are still likely in the market for a venue to recycle flows and the Dollar is now sporting more attractive yields than at any time in almost five years.

A clear upward dynamic, however, will be required to check the Dollar’s decline and begin to signal a return to demand dominance. 

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