Markets Insight From IG: February 2018

05 Feb 2018 | 10.59 am

Markets Insight From IG: February 2018

Dollar weakness won't last forever

05 Feb 2018 | 10.59 am

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2018 COULD BE THE YEAR OF THE DOLLAR, WRITES MARTIN ESSEX (PICTURED), ANALYST AND EDITOR OF IG’S FREE NEWS AND RESEARCH SITE, DAILYFX.COM

Watching a late-night BBC television show recently on a brief visit to South Wales, my attention was grabbed by a segment with a highly unusual title: ‘In support of Donald Trump’. Far from being a tribute by a right-wing conservative supporter, it was a sober – albeit tongue-in-cheek – analysis of how well the US economy has been performing since he took office.

US economic growth in Q3 2017 was a highly respectable 3.2% annualised, the fastest pace in more than two years. The unemployment rate is at its lowest for 17 years and inflation looks set to reach or rise above the Federal Reserve’s 2% target. Of course, the US president cannot take all the credit for this performance but it does raise the question of whether the US dollar, which lost ground against a basket of currencies throughout 2017, could pick up this year.

Rising Interest Rates

Trump’s Tax Bill should boost economic growth even further this year, albeit modestly. Moreover, the Federal Reserve looks set to increase interest rates steadily as the year progresses, making dollar-denominated assets more attractive. A useful indicator of where the markets are expecting the benchmark Federal Funds target rate to be in the months ahead is the CME FedWatch tool. At the time of writing, that shows a 78% chance of the rate being a quarter-point higher by the Fed’s meeting on March 12. By the meeting on June 13, there is an almost 55% chance that rates will have been increased twice, by half a percentage point in total.

At the same time, the yields on US Treasuries have been rising steadily since September. At the start of that month, the yield on the bellwether 10-year issue was only just above 2%; recently it was above 2.5% and still climbing. That potentially increases the demand for US debt at a time when some buyers, particularly the Chinese, are curbing their purchases.

Against this background, the US dollar should arguably be strengthening, as foreign investors needs to buy dollars to purchase US Treasuries. Inevitably though, it is not that simple, as interest rates are also rising elsewhere. In the UK, rates are being lifted to combat inflation, which remains well above the Bank of England’s 2% target.

In the eurozone, the European Central Bank is gradually withdrawing the monetary stimulus it provides to give the economy a lift. That reduces the relative attraction of the US dollar against both the pound and the euro.

Oil Price Rebound

In the meantime, the weakness of the US dollar last year has helped buoy up the price of crude oil. From a 2017 low just under $45 per barrel in June, the price of the global benchmark Brent crude has climbed to around $70 per barrel, increasing the risk of global inflation. That climb surprised many commentators, who were talking of a global supply glut caused by high Middle East output and US shale production. If the dollar starts to strengthen, the price of crude is likely to fall back.

As for the pound against the euro, that exchange rate has barely budged since mid-September, with the euro generally hovering between 87.5 pence and 90.0 pence. With monetary policy likely to be tightened in both the UK and the eurozone, that relative stability could well continue for many months yet.

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