Bad US economic news may not hurt the dollar longer-term


Michalis Florentiades, XM Investment Research Desk

The US dollar has experienced quite a flip-flop in the past few weeks, as a summer that was dominated by a relatively uneventful Brexit was drawing to a close. Relatively hawkish statements from Federal Reserve officials (particularly Chair Yellen) that seemed to open the door to a possible rate hike in September, have clashed with some particularly weak readings from the two most important business surveys of the world’s largest economy. In particular, the ISM’s manufacturing and non-manufacturing surveys posted sharp drops during August. The manufacturing survey dropped from 52.6 to 49.4 (into contraction territory), whereas the non-manufacturing index fell from 55.5 to 51.4. The two survey indices therefore fell by around 3 and 4 points respectively.

Consequently, the market has pretty much ruled out the possibility of a Fed rate hike in September and the dollar has taken a significant drop. The rationale is that the Fed will not take the chance of raising rates unless other data firmly contradicts what the two ISM surveys are indicating. For other data to emerge one needs time and the September 20/21 meeting is too close for fresh data to be released. This would leave the December meeting as the only realistic possibility for a rate hike during 2016 as the November meeting is only a few days before the US Presidential Election and the Fed would prefer not to be seen meddling in the process by changing interest rates a few days before.

It is interesting to speculate on what could have caused such a sharp reversal in business confidence. During the past decade, only the financial crisis of 2008 caused a bigger collapse in the ISM index. Therefore such a drop probably also needs a catalyst and in the summer doldrums of August, such a catalyst is not so obvious. One candidate however could be the US election in November. It is common for elections to introduce economic uncertainty, but many observers have pointed out that this particular US election could attract extra attention. One of the candidates, Mr. Trump has been characterized as anti-establishment and there is a strong undercurrent of popular resentment, which could result in surprising outcomes (Mr. Trump’s candidacy was initially seen as a long shot). In particular, the anti-free trade agenda of Mr. Trump could cause economic disruptions, although both candidates are also in favor of fiscal stimulus (to varying degrees). In the past it has been suggested that an argument against a September rate hike was that it could add to an uncertain environment ahead of a US election that could have wider implications.

To sum up, the next 2-3 months could be challenging for the US dollar if the string of weak economic data persists and election-related uncertainty causes investors to be a little more cautious when deciding about whether to invest in the United States. The dollar’s status as the safe-haven reserve currency and the United States’ economy as the best house in a bad neighborhood could be questioned. This could be facilitated by the unwinding of excessive positioning in favor of the US dollar.

At a longer-term horizon however, given the current set of fundamentals and circumstances, it is difficult to expect a dollar bear market. What usually happens is that the US dollar index will test the boundaries of its range and bounce back up. This has been the case since the end of 2014. What dollar bulls did receive in the past few days was probably a warning shot that the next 2 months, in the absence of a Fed rate hike and as an uncertain US election looms ahead, the dollar is in turbulence.

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