*We do not trade currencies. However, our outlook on the U.S. dollar impacts our U.S. stock market outlook a little bit.
The U.S. dollar remains stubbornly high and has been going up slowly and steadily over the past 2 weeks. The key to understanding the U.S. dollar index is to understand the Euro, which makes up for more than 50% of the U.S. dollar index. Previously, we were bearish on the U.S. dollar and bullish on the Euro for the following reasons:
- The Eurozone economy is expanding rapidly from the bottom of its previous contraction. Eurozone economic data and inflation surged in late 2016 and Q1 2017. The Euro went down on deteriorating Eurozone economic data in 2014 and 2015, and now that Eurozone economic data is improving the Euro should go higher.
- The ECB was expected to taper its QE program sometime late-Q1 or Q2 2017. Then the ECB was expected to start hiking rates, thus making European bonds and hence the Euro relatively more attractive to investors than the U.S., which is merely maintaining its rate hike course.
*The French election is not a danger to the Euro. Far right candidate Le Pen has absolutely no chance of winning. Her odds of winning are far lower than Trump’s odds before the U.S. election.
However, the Euro has been falling over the past 2 weeks and the USD has been rising. With price action going against our bearish outlook on the USD, we must re-examine our case.
The bullish case for the USD and the bearish case for the Euro
Several pieces of news have come out over the past few days that raised our attention.
- The ECB has no plans to taper QE right now. Investing.com
- While many people expected the ECB to taper QE, the ECB has actually ramped up QE! Zerohedge
- Trump’s pro-growth tax plans are dead in the water. He has scrapped his entire previous tax plan and might only pass a watered down version after Congress’ summer recess. Zerohedge
- The Eurozone’s economic data has been mixed over the past 2 weeks, a notable change from the data of previous months that handsomely beat expectations.
- Jeff Gundlach expects inflation to be flat for the next few months.
- Congress is on vacation right now for 2 weeks. Meanwhile, the government funding expires on April 28, after which Congress will have 5 days to pass a spending bill and avoid a government shutdown (last happened in October). Bloomberg
The first 2 points – the ECB not tapering as expected – is bearish for the Euro and bullish for the USD. In all fairness there is no reason for the ECB to taper right now. The Eurozone economy has just started to rise from a soft landing. Why would the ECB want to take away its market injections now and risk a double dip in the economy? A double dip would render all of the ECB’s efforts to waste. Why not taper AFTER the Eurozone economy is already growing robustly and on very solid footing? Keep in mind that the Fed only started to taper in 2013, YEARS after the U.S. economy had bottomed.
So if the ECB does not taper as expected (or tapers much later than expected) and the Fed continues its current rate hike path (which it probably will), the interest rate differentials between the U.S. and Euro widen. Hence investors will be more attracted to U.S. bonds, so money will flow into the U.S. and push the U.S. dollar higher.
The 3rd point – Trump’s pro-growth tax cuts being dead – is interesting. The media declared that the U.S. dollar went up from November-December 2016 because of the “reflation trade”. Basically, the market expected Trump to pass his pro-growth policies, which would boost the U.S. economy and attract money flow into America. Thus the USD would rise.
Now that Trump’s pro-growth policies are mostly dead, the U.S. dollar is still going up! This means that the USD is no longer going up because of the “reflation” theme. It’s going up for other reasons. Trump is now mostly irrelevant to the U.S. dollar.
Coming out of a soft landing, Eurozone economic data surged in Q4 2016 and Q1 2017. However it’s important to remember that economic data always improves the fastest when the economy bounces back from the bottom. Now that the Eurozone economy has been lifted from the bottom, Eurozone economic data will improve at a slower pace. With the U.S. economy and Eurozone economy both improving at the same slow pace, there is no reason for businesses and investors to take their money from the U.S. and move it to Europe. Thus this bullish factor for the Euro has disappeared.
Likewise, global inflation (a sign of global economic growth) will be flat for the next few months after surging in late-2016 and early-2017.
On the final point – a government shutdown in early May – the U.S. dollar historically goes up more often than it goes down during government shutdowns.
What does this mean for U.S. stocks
Not much really. There has been a slight positive correlation between the S&P 500 and the US Dollar Index over the past few weeks, so perhaps a rising USD will push the S&P 500 higher in the short term.
Also note that historically government shutdowns have had NO impact on U.S. stocks. The U.S. stock market often rises during government shutdowns.
But remember that the USD has no impact on the S&P 500 over the medium-long term. We invest in for the medium-long term, and we are still bullish on U.S. stocks.