July employment report gives hope to dollar bulls following GDP, Fed disappointments

Michalis Florentiades, XM Investment Research Desk

The US dollar was under intense pressure during the period July 27 – August 2.  During this period the dollar index suddenly lost about 2.5% of its value – a brutal move for the world’s reserve currency.  Following some encouraging news out of the US economy such as personal income and spending and the ISM non-manufacturing index the dollar started a recovery which received a big boost from a very strong US employment report.

The employment report was better-than-expected in a number of ways; it wasn’t the usual ‘good news on this was countered by bad news on that’.  Not only did the total number of payrolls increase much more than what analysts expected (255k vs 180k), but wages were also stronger and the workforce participation rate also ticked up.  Unemployment stayed constant at 4.9% but unemployment lower than 5% is a significant achievement for the US economy already and does not need to improve much.

Of course one can point out the volatility of economic indicators such as payrolls and also point to the weakness displayed by the most comprehensive indicator – that of Gross Domestic Product which sums up the economy’s output.  Even more important however is the spin that the Federal Reserve board is giving to the numbers and how it sees the economy and monetary policy.  The Fed is trying hard to be unbiased but it also needs to have a frame through which it interprets these developments.

In addition to the US economy, two factors in particular seem to be weighing on the Fed’s mind.  The first is global factors and the state of international financial markets.  This was in display earlier in the year, when it decided to postpone a rate hike because global markets were in turmoil and there were also some fears about China’s economy and the stability of its currency, the yuan.  The second factor is less obvious but nevertheless probably present.  As major central banks around the world are pursuing ultra-loose policies such as cutting rates (sometimes to negative) and quantitative easing, the Fed could be conscious that going the other way and increasing rates at a fast pace could lead to a strengthening of the dollar and the absorption of too much foreign money by the US economy for the country’s own good.

Therefore the Fed might appear to be more dovish than justified by a sub-5% unemployment rate, a core PCE inflation rate of 1.6% (or 2.3% in core CPI) and a growth rate around 2-3%.  In this way, despite the Fed’s dual mandate of full employment and price stability referring only to the domestic economy, in a globalized, post-financial crisis world the Fed needs to pay attention to what is happening outside US borders.  The conclusion from this is that US rate hikes might be slower and smaller than what is justified by the US economy alone.  This could have a restraining effect on US dollar upside and the dollar index looks like it will remain in a broad trading range between 90 and 100.