MorningWord 4/13/16: The U.S. Dollar Holds the Key?!

by Dan April 13, 2016 10:31 am • Commentary

The financial press likes to condense potential market catalysts down to this or that is the KEY to an upcoming event. For instance here are a few headlines I have seen or heard this week:

Iran’s participation in the upcoming OPEC meeting in Doha is KEY to securing cuts in oil production.

U.S. Federal Reserve interest rate policy is KEY to U.S. banks earnings growth.

A Weak U.S. Dollar is KEY to profit growth for U.S. multi-nationals in 2016.

As we head into the meat of Q1 earnings season in the coming week I would say all of the above are sort of KEY. But more importantly, they’re all inter-related. We know that the Federal Reserve’s monetary policy of QE and ZIRP in the wake of the financial crisis was a in effect a policy to weaken the dollar, subsequently causing a massive rally in dollar denominated industrial commodities like oil.  When the Fed pulled the rip cord on QE in late 2014, the dollar ripped and oil collapsed, which was further hastened this past December with the Fed’s first rate increase in 9 years:

DXY vs Crude since Jan 1, 2014 from Bloomberg
DXY vs Crude since Jan 1, 2014 from Bloomberg

For those who think we may have these two charts converge, one might consider the wall of technical resistance that crude oil faces in the high $40s and the massive support the US Dollar index (DXY) has in and around $94. Every time the DXY has gotten to $94 or slightly below since the start of 2015, it has been a great buying opportunity, with numerous instances of 3 to 5% rallies during that time period:

From Bloomberg
From Bloomberg

Is there any reason why this time will be different? U.S. economic data has been better than expected recently. If that were to continue in the coming months that likely means a second rate increase for the Fed. (The timing becomes the only issue) That anticipation of a rate hike would strengthen the dollar. And with U.S. stocks just a hair from all time highs, higher rates and a higher dollar could (would?) would bring back the sort of volatility in equity markets we witnessed in January and February when the DXY was above $98.

The Fed knows all this of course and they seem to be caught in a game of chicken with financial markets. Score one for our central bank with their talking down of the dollar since February, as they were seemingly caught in a conundrum since their December rate increase with a divergent monetary policy to the likes of China, Europe and Japan, a conundrum that caused a good deal of risk asset volatility. So whether or not this was a coordinated action, or just a strategic strike to crush volatility, the data dependent Fed will need to once again do an about face on the dollar if our economic data continues to improve. It’s all fairly confusing to consider how they will gently land this plane, but it appears that the Fed will have a new dual mandate in 2016. Avoid a risk asset crash with gradual interest rate raises, while also avoiding the creation of a risk asset bubble by leaving monetary policy too easy for too long.