Tags: dollar | euro | BOJ | US

What I Expect the Dollar to Do During the Next Few Years

Tuesday, 12 August 2014 10:49 AM Current | Bio | Archive

About a month ago, I wrote that the downward path of the euro was definitively drawn, but I refrained from giving my view on where I expect the dollar to move against other currencies during the next couple of years.

In the meantime, European Central Bank (ECB) President Mario Draghi, during his monthly press conference after the ECB Governing Council kept its key interest rates unchanged last Thursday, gave the following interesting remarks concerning the exchange rate of the euro and in which context the ECB sees it: "The fundamentals for a weaker exchange rate are today much better than they were two or three months ago. And this depends on factors that were, in a sense, in the baseline, like a slowing net trade surplus, but also depends on factors like there has been a decline in short-term capital inflows. . . . Markets had perceived that the euro, that monetary policies in the euro area and in the United States are, and are going to stay, on a diverging path for a long period of time."

In understandable English I can't call that a positive statement on the euro. And yes, this is of great importance for long-term investors.

So let's take a look at what can be expected of what could be behind the dollar's performance against a few other major currencies in the foreseeable future:

The dollar is definitively on its way for a steady appreciation against most of the major currencies, thanks to its strengthening fundamentals, but, of course, it won't be a straight line up. It is important to take notice the latest U.S. Conference Board Employment Trends Index to 120.31 in July, up from an upwardly revised 119.92 in June and up 6.6 percent year-over-year. The growth rate for the last six months was the strongest in more than two years, thereby confirming the strong positive momentum we have noticed lately.

Besides, the U.S. Institute for Supply Management's manufacturing composite index, which is a diffusion index calculated from five of the 11 sub-components of a monthly survey of purchasing managers at roughly 300 manufacturing firms nationwide, increased to 57.1 percent up from 55.3 percent, with new orders up coming in at 63.4 percent, the best reading of the year, from 58.9 percent in June.

Personal income and spending both increased 0.4 percent in June, while consumer confidence jumped to a new expansion high at 90.9, all pointing to continued acceleration in third-quarter U.S. economic activity.

One should not overlook the fact that the dollar index (DXY) is still approximately 8 percent below its Millennium average, which some see as an indication of the coming destruction of the dollar, but which is also a positive and could easily permit a quiet appreciation path that could easily have the dimension of at least that same 8 percentage points. However, this time it wouldn't cause any serious form of overvaluation concerns.

To me it's an undeniable fact that if the U.S. economy continues to grow as it is performing now, the Federal Open Market Committee will not be able to maintain its dovish inclination far into next year because it might find itself behind the curve in its tightening efforts, which would be an undesirable place to be.

The euro, on the contrary, is for most of the eurozone member states, economically and politically, in overvalued territory because its fundamentals are not good at all and continue once again to deteriorate. Most importantly, France and Italy, which are the second- and third-largest economies of the eurozone, are in deep trouble.

To describe France's situation, maybe Pierre Gattaz, president of MEDEF, which is France's business federation, said it all when he called the economic situation in France "catastrophic" a few days ago, while Italy went back into recession in the second quarter, as its GDP contracted -0.2 percent after declining -0.1 percent in the first quarter, while youth unemployment remains at an horrendous 40 percent.

The monthly ZEW indicator for economic sentiment in Germany, which is conducted by the Center for European Economic Research, tumbled 18.5 points to 8.6 points, compared with the long-term average of 24.6 points, and hit its lowest level since December 2012. The assessment of the current economic situation in Germany also lost a substantial 17.5 points to 44.3 points.

The ZEW Indicator of Economic Sentiment for the eurozone also declined in August and lost 24.4 points to 23.7 points. The indicator for the current economic situation in the euro area decreased in August by 2.3 points to a value of negative -33.8 points.

It will be really interesting to see the flash GDP estimates for the second quarter that will be released on Thursday. Yes, unfortunately, the euro area is back in intensive care and needs urgently to jump start inflation, have a cheaper euro while it must continue its structural reforms. How they are going to achieve that is the million-dollar question for which neither the ECB nor anybody else seems to have a good answer.

For the pound's future performance, I expect it to be somewhere between the performances of the dollar and the euro, under the condition the euro doesn't go to parity with the dollar, which is a low-probability scenario but that isn't impossible either. As of lately we have learned that the strong pound sterling hasn't had that benign force that so many had predicted and notwithstanding all those reassuring talks of the price inelasticity of UK exports there have been no mitigating circumstances for those corporations that have been repatriating their profits, but to whom the soaring pound has had savaging effects that have resulted in more than $2.5 billion that have been wiped out from the year-to-date profits of a rather limited string of top multinationals.

Also Ernst & Young data show a number of profit warnings across industry in recent months, all because of a too strong pound.

As far as the Japanese yen is concerned it's actually going nowhere and remains at a way too strong level to help the objectives of Abenomics, or better said it's not weakening rapidly enough and therefore it will need a fresh boost from the Abenomics' tools arsenal. For example, when we look at Japan's core inflation and we strip out the April's sales tax, inflation in June was 1.3 percent, down from 1.4 percent in May and 1.6 percent in April. Too low Japanese inflation is actually for a great part a consequence of the fact that import prices can't be stoked up by a weaker (or weakening) yen.

No wonder at the Bank of Japan (BOJ) board we have seen very strong discussions about the specificity of its 2 percent inflation mandate, The current projections under the current circumstances don't give any hope achieving the 2 percent inflation mandate in the foreseeable future, while, at least so far, the BOJ has resisted any form of intervention.

Nevertheless, I think this situation could change promptly, and not because Japanese exports have now fallen for two consecutive quarters, which in turn have caused the largest drop in industrial production since the Japanese economy faced the awful events of 2011 and when its GDP was 537 trillion yen, the same level as it was in 2005. I personally have no doubt we'll see renewed Japanese yen weakness that is on its way. Of course, I could be wrong, as could anybody else

As countries like Australia, Canada, New Zealand, South Korea and most of the emerging economies all have apparently now also set their eyes on weaker currencies (against the dollar), we could ask ourselves if the Federal Reserve would remain unmoved in case the dollar would steadily be gaining strength across the board?

In all honesty, this is a question that is difficult to answer because all will depend on the strength of U.S. economic growth. If good and better growth takes further hold there is no doubt the Fed will be obliged to become less dovish next year and as the U.S. economy is not overly dependent on exports, it is highly improbable the Fed would try to manipulate the dollar down.

Because of rising important and dangerous geopolitical risks in many places around the globe, I expect a further strengthening and upward trend for the dollar, which will undoubtedly have an impact on many long-term oriented portfolios.

Long-term investors should always stay wary, alert and very nimble, the complete opposite of acting with herd mentality.

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Because of rising important and dangerous geopolitical risks in many places around the globe, I expect a further strengthening and upward trend for the dollar, which will undoubtedly have an impact on many long-term oriented portfolios.
dollar, euro, BOJ, US
Tuesday, 12 August 2014 10:49 AM
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