The Almighty Dollar Triumphs Again, But 2017 Is In Doubt

The initial consensus forecast was for a slight improvement, somewhere just south of 1%, assuming four Fed rate adjustments. Even with only a single rate hike, the USD Index shot above 103, its highest point since December of 2002. The projected appreciation of 4.375% serves as evidence that central bank policy divergence is, perhaps, stronger than was originally conceived. Yes, the Brexit vote did pound Cable into submission, but nearly all other central banks have expanded their respective easing programs, to no avail, we might add.

In case your memory is short, here is a quick rundown of financial market events :

• The Fed surprised everyone early in the year by changing its previous outline for future interest rate hikes. The USD, as a result, fell from grace during much of the year. Then, as other central banks kept expanding their QE programs, the Almighty Dollar began to rise from the ashes;
• Chinese stock markets were under stress for all of 2016. The meltdown of the Shanghai Composite had begun in 2015, but it continued in 2016, based on fears that the Chinese economy had not found a soft landing and that the Yuan would be devalued over time. The PBoC did intervene on occasion to dampen reactions, but the Shanghai roller coaster just kept on rolling;
• Oil prices dominated much of headline news for the year. The shocker in February was when crude oil prices dipped to just above $26 a barrel, its lowest point since May of 2003. Stock indices were down, as well, but oil ended the year hovering around $53. Stocks also rebounded, with the Dow Jones Industrial Average about to set records by piercing the 20,000 level;
• When the “Leave” vote emerged victorious after the Brexit referendum, gold rose in ascendance, peaking at $1,364 an ounce. The sudden rise harkened a rebirth of precious metals, which soon became popular. This small Bull Run, however, was short lived. The U.S. stock market rally and irrational exuberance that followed Trump’s election victory quickly poured water on the fires breathing life into the metals sector, sending Gold down to $1,130. Despite its fall from grace, many gold-bugs foresee a “Perfect Storm” building for the yellow metal, with inflation expectations the ultimate driver;
• The forex market may have been the best place to be, with roller coaster trends prevailing on several fronts. The Canadian Loonie was buffeted by rising oil process. Pound Sterling plummeted after Brexit, bouncing off a 31-year low of 1.202 and wavering around 1.228 at the moment. The euro and the Aussie were range-bound for most of the year, having sustained the majority of their losses in 2014 and 2015, when the greenback went on its tear. Both declined sharply during the final quarter of the year, with analysts screaming that the euro was headed for parity with the USD or even lower;
• When Donald Trump secured the White House, financial markets initially went into a tailspin, but U.S. domestic stocks suddenly reversed and rallied, based on the supposition that tax cuts, regulation rollbacks, infrastructure spending, and military expansion would be positive for business. Global indices, however, dipped, but did not recover, since early indications from Trump advisers have been that trade relationships will be revised to favor American interests, uncertainty at its best.

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As Trump-phoria rampaged through the financial markets, the U.S. Dollar went on another appreciation romp in anticipation of the Fed finally instituting its rate hike agenda in December. Real interest rates, the actual rates that borrowers face in the market, had been rising since mid-year. Bond prices had cratered in response. Treasury yields spiked up, as well, signaling a potential end to the long-term Bull market in bonds that had lasted for decades.

The theme on the street was that Trump’s proposals would create a wave of inflation, as various stimulus accommodations spurred on industrial output. Others, however, were not so sure. Our economic woes have been more tied to oversupply issues, stemming from a complete lack of accelerating demand across developed and developing markets. The prospect of more on the supply side staggers credulity, and, when you combine higher interest rates with an appreciating USD, history tells us that this combination is lethal. As a result, the “R” word, recession, is appearing in more and more articles of late, even though trusted models have yet to signal its possibility.

Over the proceeding years, the Fed has crafted a complex quilt of near-zero interest rates, quantitative easing, and now, a forecast of programmed rate hikes over the next three years, its form of interest rate normalization. The only problem is that the Fed governors are not in agreement on how Trump’s policies could wreak havoc on their carefully woven design. The fed may have increased rates, but it left its inflation forecasts as they were, targeted at 2%. No one is quite sure if Trump will herald a new age of inflation or not.

And so the storylines become clear. Will Trump’s real actions create the inflation that everyone expects? Will global markets have difficulty with an ever-appreciating USD? Will the Fed follow through on its plan for interest rate normalization? Will the UK start the official process for withdrawing from the EU? Will international trade agreements be in disarray? Will leading indicators point to a recession at the end of 2017? These will be the major questions for the year, and these do not include anything about escalating political tensions in Europe, the Middle East, Russia, or elsewhere. Time will tell us all.

If you like roller coaster rides, then 2017 could be a good year for trading foreign exchange. Each of the above “questions” has an element of timing attached to it, which means that markets will more than likely over react, before establishing a new level of support. For once, ranging behavior may not dominate the markets. Uncertainty equates to volatility, and volatility translates into opportunity for all forex traders.

The presence of uncertainty is readily apparent in current forecasts for the USD Index for the ensuing calendar year. The conservative side, if you can call it that, believes that the Dollar will remain strong and get stronger, perhaps, by 3% on the upside. The other side of the house is betting on just the opposite scenario, predicting that the index will decline by 3%. It is still early in the game, and many forex departments are putting the final touches on their respective guesstimates. In other words, many are hedging their bets for now.

Traditionally, the “USD/JPY” pair has been indicative of the condition of the market. If it is stable, then market conditions tend to follow suit. Both the Yen and the USD tend to be the “base currency” for highly lucrative carry trades, which by most estimates exceed $12 trillion in current positions. What is the range of forecasts in this arena? Today the pair is roughly 117. Here are four predictions from some of the world’s finest: JP Morgan: 99; Citibank: 114; Nomura: 120; Deutsche Bank: 120 – 125. The arithmetic average is 114, which is about where most other experts place it. The question is what would have to happen to achieve the extremes on either side of this distribution?

Here are the current ranges for other major pairings:

EUR/USD: Now at 1.0547 – Current forecast range = 1.00 to 1.10. Parity with the greenback is a real possibility, and, if this happens, many suspect that it will go well past the mark before recovering;

GBP/USD: Now at 1.2322 – Current forecast range = 1.16 to 1.25. The range is nearly one thousand pips, depending upon the severity of Brexit negotiations;

AUD/USD: Now at 0.7227 – Current forecast range = 0.70 to 0.75. China and commodities must recover to bolster any gains in the Aussie;

USD/CAD: Now at 1.35 – Current forecast range = 1.36 to 1.42. No one seems to think that Canada will benefit from higher oil prices.

2017 is off and running. What will the major stories be, and how will our foreign exchange market react? The current thinking is one of uncertainty, especially when it comes to the actions to be taken by Donald Trump during his first one hundred days in office, the defining period for any new presidency. Expect quite a few twists and turns, as the ride develops. Roller coasters can be fund. When a strong trend presents itself, jump on the train and ride your way to easy profits. When the trend reverses, there will be another train waiting at the tracks. It should be fun. Happy trading!

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Written By: Jay Hawk