Late last year, practically everyone was pencilling in a rise in the dollar for 2016. But as market history has shown again and again, when everyone believes in a story, there are not going to be many buyers left, so the trend can easily run out of steam and reverse.
The US dollar has done exactly that. After a rise of 20% in trade-weighted terms in the 18 months to the end of January, it has since fallen by around 4%. Against the euro and the yen it has lost a respective 5% and 7%.
A key reason for the reversal has been increasingly dovish signals from the US Federal Reserve. Last week, its chair, Janet Yellen, cited worries about global growth as a reason to “proceed cautiously” with interest-rate rises. Now the Fed is pencilling in only two interest-rate hikes for 2016, while at the turn of the year its forecasts implied four.
Still, this isn’t just about the Fed, says the Buttonwood columnist in The Economist. Emerging-market currencies have rallied against the greenback due to improving sentiment towards commodities. And further monetary easing by the European Central Bank (ECB) and the Bank of Japan (BoJ) has not led to renewed falls in the yen and euro. The fuss over negative interest rates and their impact on bank profits may have dented confidence in the central banks’ ability to loosen policy further.
Is this just a pause in an uptrend, or has the buck stopped? “Few believe [the dollar] is down for the count,” says Ira Iosebashvili in The Wall Street Journal. “A burst of strong data could put interest-rate hikes back on the table.” The inflation outlook is especially important here. Core inflation has risen recently, reaching a four-year high in March, and analysts are increasingly worried that the Fed may not be paying enough attention to it (see below).
If the Fed ends up behind the curve, it may have to raise rates faster than currently expected, and that implies a further increase in the dollar as investors price in dearer money to tame inflation.In the meantime, both the ECB and BoJ have hinted at additional easing measures. So there is scope for a dollar bounce as “monetary policy divergence once again becomes the dominant theme”, reckons Capital Economics.
In the meantime, says Buttonwood, the change in the trend for the dollar has simply shifted the problem with global growth around. A strong dollar was bad news for emerging markets as it increased the weight of dollar-denominated debts, hit commodities, and made risky assets less appealing (see page 7). Now, a weaker one is a headache for Europe and Japan, which were “counting on exports to revive their moribund economies”.
Is inflation about to take off?
Last Friday’s US employment data was even more keenly awaited than usual, with investors combing through the report to gauge the outlook for inflation and interest rates. In the event, it appeared to contain something for both hawks and doves: unemployment is still improving at a steady pace, but not yet fast enough to give workers much negotiating power to press their wages upwards, says the FT’s John Authers.
Payrolls grew by another 215,000 in March, taking the tally over the last 12 months to an impressive 2.8 million. The unemployment rate ticked up from 4.9% to 5%, but that was because previously discouraged workers have returned to the labour force, which has jumped by over two million in five months. This flood of supply may be tempering wage growth. Average hourly earnings are expanding by just 2.3% year-on-year.
This is not the full story on wages, however. Average hourly earnings are a widely watched indicator, but hardly the only compensation gauge out there. Many of the others have “tilted higher”, as Bank of America Merrill Lynch points out. “The general sense one gets from the most commonly cited series is that wages finally started to pick up last year.”
Anecdotal evidence, such as surveys of firms’ expectations about labour costs, is also piling up. The upshot is that “there is the potential for some encouraging wage growth figures over the next few months, as pent-up demand in the labour market starts to translate into more rapid pay rises”, says ING Commercial’s James Smith.
That would further rattle those who already think the Fed is “taking a major gamble” by allowing inflationary pressure to mount; core inflation is already looking robust, as Ambrose Evans-Pritchard points out in The Daily Telegraph. On the Fed’s preferred PCE core inflation measure, it has jumped sharply too. The odds of a sharp, destabilising rise in interest rates to keep a lid on a jump in inflation may be rising.