Early in April, we were officially bearish the U.S. dollar for the intermediate timeframe (see our April 5 note). That was in lieu of the more than dismal March non-farm payroll. Almost 2 months forward, we are now revising our outlook while maintaining our bias on the greenback. In today's piece, we will be outlining several key point what will shape our guidance going forward.
With language from the Fed contradicting both the street's expectations and what current economic data suggests, we feel it is crucial that investors and traders take a better look at the situation on the ground. We should however preempt readers that our bias may shift at any given point in time, and is heavily dependent on both market forces and the fundamental dynamics that are responsible for the dollar's performance in the currency markets.
Apart from the dollar, we will also be briefly going over several major currencies to reflect a more detailed bias now that we feel the fog has cleared a little.
In short: We maintain our bearish bias until technical factors change or fundamentals improve.
U.S. Economy Remains An Enigma
We've said it in countless occasions and we will say it again. The U.S. economy is one big paradox. It is well known that 1Q15's 0.2% (QoQ) GDP growth came as a major nasty surprise. It was just 4 weeks after March's NFP printed in the low 100s - that development almost ended the debate if the payrolls were a singularity in itself.
Apart from a very frigid first quarter, other economic indicators such as industrial production, durable goods, and manufacturing PMI figures proved the point that the U.S. was indeed in a economic cycle of decelerating growth; rapidly waning private investments, consumer and small business sentiment; and a consumer that was now ever more willing to save than spend.
We have covered how the American economy was missing analyst expectations by the farthest since 2009, but made the caveat that it might be a tale of expectations running ahead of reality. However, given that data continually disappointed despite more realistic forecasts as of late, wrecks that native defense.
April Payrolls Recovered Unconvincingly
Early in May, when the market was just about to light the tinder underneath the Fed's relative hawkishness, April's non-farm payrolls recovered fully from March's disaster. 223,000 jobs were added in April, practically meeting expectations. The widely followed U3 unemployment decreased to 5.4% from 5.5% in April as expected, the lowest in the aftermath of Lehman.
April's report did though add insult to past injury, by revising March's jobs gain to 85,000 (weakest since June 2012), which was nearly 30% under the initial figure. Wage growth, a key variable that the FOMC watches closely, was weak in April. Average hourly earnings rose a paltry 0.1%, below the 0.2% expected and down from the pre-revision 0.3% gain in March (which was itself revised lower to 0.2%). Real average hourly earnings increased by 0.4% (factoring in CPI deflation of 0.2%).
The fact that financial media called April's report a "goldilocks" one serves to illustrate the case of the market's undecidedness of whether to view the relative steadiness as positive enough to convince the Fed to raise rates, especially after repetitive comments from Chairwoman Yellen that some slack still exists.
In 2 week's time when May's payrolls report is due, we will have more clarity if March's disappointment was merely a red herring or a harbinger for more cyclical downside. It is difficult to base our judgement on the labor market at this juncture but we will give the prevailing trend (of payrolls averaging above 200,000) the benefit of the doubt here.
Jobs Market Remains Robust
Adding complexity to the labor market dynamics are the consistent weekly initial jobless claims. For almost every week that data has been published, jobless claims have trended lower, and now sit at levels seen in 2000. We are not surprised.
We are not surprised because it is widely agreed upon that the jobs creation has been the strongest front of the U.S. economic recovery. Obviously, this view is difficult to contest. That being said, it might be unwise to use this status quo as a motivation for progression towards eventual tightening by the Fed; although it remains an unlikely possibility.
Broad Deflation Vs. Core Inflation
Post the crash in global oil prices since mid 2014, the topic of inflation or the lack thereof has been a diabolical one. Case in point. On Friday's the U.S. reported its April CPI figures and depending on how one sees it, it might be good or bad.
The plus: Core inflation (ex. energy and food) came higher than expected both YoY (1.8% vs. 1.7% exp.) and MoM (0.3% vs. 0.2% exp.). Annual core inflation was unchanged over March's 1.8%; and increased by 0.1% over March.
The bad: Broad inflation (or rather, deflation) came in at -0.2% YoY (-0.1% exp. & previous), and 0.1% MoM (0.1% exp. & 0.2% previous). It was in March when the U.S. economy officially slipped into deflation (see our March 1 note), and has not recovered since.
Remember that the Fed's mandate is to achieve a 2% inflation rate, the current -0.2% has never been more distant. Oil prices bottomed in March, while gasoline prices actually saw their lows in early February. We are curious as to the reason why rising fuel costs at the consumer level has not filtered down to a higher broad inflation rate.
Obamacare Boosts Economy
While we find it hard to conjure optimism about the absence of broad inflation, we can explain why core prices surged their most since 2013 - healthcare costs (aka Obamacare). Prices of medical care services rose by a whopping 0.7% in April, a primary attributive factor for the increase in core prices.
While stalwart protagonists may argue that rising core prices are a signal of an economy that is heating up, the real reason may be much simpler - much higher health insurance premiums as insurers start to revise their prices upwards after more than a year of evaluation.
The Affordable Care Act, also known to the layman as Obamacare, was rolled out almost 3 years ago making it mandatory for all employed Americans to be insured under at least one healthcare insurance policy. Employers were to bear a portion of the insurance costs.
For almost 2 years now, insurers have restrained from jacking up premiums primarily because they were uncertain about the effects Obamacare would have on their earning; leaving premiums more or less as they were. Gradually, as it became clearer that Obamacare meant that their liabilities would increase dramatically, insurers started revising their rates higher to reflect the advent of a radically new landscape in the insurance industry.
It was only until the start of 2015 when the effects of the mass upward revisions became apparent in core price metrics, which is what we are seeing today. The WSJ reported that major health insurers were seeking to increase premiums by as much as 50% over the course of 2015, and policies that were incepted this year would be subject to the revised premiums.
It is clearly a supply and demand issue, and it so happens that there is enormous demand in this case; demand for healthcare and medical services. The is the primary reason why healthcare stocks absolutely surged in 2013 and 2014, and also the reason for 3Q14's spike in GDP growth.
In our eyes, this does not reflect a strengthening economy but may be cynically viewed as regulation that forces the private sector to spend more, which is perhaps a fiscal ingenuity on a whole new level worthy of a Nobel Prize.
April FOMC Minutes Says No Rush
The Fed still holds the lynchpin to the dollar's future trajectory. We therefore place high emphasis on not only the comments of various FOMC voting member but also their policy meeting statements and minutes. Ever since the Fed dropped "patience" from their official language in March, the dollar has never traded without throwing interluding tantrums to the wimps of macro economic data, market positioning and sentiment.
The minutes for April's FOMC meeting released last Thursday indicated to us that the Fed was in no hurry to raise interest rates.
They ruled out a June rate hike and mentioned that they believed weak economic data from the first quarter were due to "transitory factors" and should see a rebound towards the second half.
The minutes also acknowledged that the Fed saw a risk of heightened volatility spilling out of the treasury market and that they would address that by raising rates in small increments.
Most of the rest comes as repetition from past minutes. We interpret this as "no rush to raise rates", and it makes a lot of sense logically. We feel the risks to the economy if a rate hike were delayed beyond September are minimal.
With inflation expectations still much below their 5-year average, the only risk we see is a falling stock market when money flows back into treasuries. The Fed does not really take that into consideration, although Yellen did mention that she believed equities were somewhat overvalued.
The risk of tightening too early are contrarily high. A stronger dollar weakens the trade balance, higher interest rates means higher borrowing costs which will hit private credit markets if consumers and homebuyers cut back at the wrong time.
As we see it, this asymmetric balance will deter the Fed from an impulsive tightening path. We believe the Fed wants to be convinced about an economy that can absorb the shocks of a rate hike without tipping off balance. The time isn't now.
We note the anecdotes from Chairwoman Yellen last week which pointed the market in the direction of a 2015 "liftoff" although no specific date was given. This is in contrast to the most recent statement where the FOMC removed a date reference altogether; and perhaps highlights the polarity amongst the voting members. Take note of the "dots".
Technicals Paint A Mixed Picture
aving aired our opinions that the fundamentals do not currently support a stronger dollar, we turn to the technicals. Technical factors have proven time and again to be potent influencers on the markets. One only has to look at the most recent rout in German bunds to appreciate this; where the selloff in Europe's safest bonds was almost fully the result of a flight out of an overly crowded trade predicated on front running the ECB's QE purchases.
Some of the said technical factors include (but are not limited to): Market positioning, price action, and cross asset fund flows. In our eyes, we cannot view the dollar on its own; the performance of currencies have to be measured against other currencies for analysis to be meaningful.
That being said, we feel the landscape as painted by these technical factors is mixed at best.
Starting with market positioning, the net speculative exposure on currency futures and options which involve the dollar has moderated. Every week, the CFTC releases what it calls the Commitment of Traders report (CoT), where gross exposures of 2 main categories are reported.
Speculators, which include banks, funds, and traders, make up the bulk of outstanding notional in the currency futures and options market. Strong and defined trends are usually fueled by this category of market participants. We have previously covered the topic of an overcrowded dollar trade, where speculators had built up a gigantic net long dollar positions against other currencies, chiefly the euro.
In March, several catalysts sparked furious liquidations of long dollar positions, leading to mayhem and a period of high volatility in dollar-based assets.
The primary counter currency of the long dollar trade was the euro, where speculators had built up a record net short exposure on the euro - bolden by an ECB which had launched its own open-ended QE program.
Once the capitulation started, the overly crowded trade turned into a pain trade, where fresh positions which were entered into at unfavorable prices suffered immense losses as prices went against them. These positions were the first to be squared, and that led to a cataclysmic chain reaction.
Almost 3 months later, there are certainly signs that the market environment has partially normalized. Volatility has tamed down, while the notional of net long dollar positions has seen a fair decline. Giving the bullish trend in the dollar the benefit of doubt, this tapering in long exposure can be seen as a healthy sign. This is the plus for an argument for continued strength in the dollar.
The minus, as we see it, would be price action. Refer to the chart of the dollar index at the onset of this article. Price current sits at pivotal zone where we feel could thrust prices lower. Former support which was negated back in April now stands as resistance. Our metrics indicated that the interim trend in the dollar index is still down. Only a break of the corrective highs seen in early May changes this bias.
Technical indicators which we look at have reached relatively overbought levels, signaling that some downside can be expected. Whether this development is seen as strong bullish momentum for a strong dollar proposition or whether it is seen as a sign that the dollar has gotten too expensive, depends on the macro picture.
The macro picture, as we have explained, does not support the case for a higher dollar. We therefore view recent price action as a corrective advance rather than an impulsive one.
Caveats To Our Bias
Our bearish view for the intermediate term will change if key technical levels are taken out, in which case we will be reevaluating our bias. But for now, we remain firmly bearish the U.S. dollar until we feel this stance needs to be reworked.
While we refrain from giving advice on how retail traders should speculate on any eventual outcome, we have adopted the strategy of avoiding unnecessary exposure on the dollar in our trading books.
Plenty of opportunities exists outside the universe of he greenback. Traders only need to look farther out to see them.