This week the downside break of the US Dollar uptrend seems to have been confirmed. As the direction of the US dollar is central to allocation across all asset classes this is worth a closer look. If you get the direction of the US dollar right you get a great deal else right too.
As the Federal Reserve has essentially shifted to a stock market standard, where stock market corrections will be limited by all “tools” necessary, they must be concerned by the relentless weak trend in economic data. The Fed’s ability to support equities could become increasingly challenged without some help from another source.
The chart below shows that US macro economic data is now as weak as it has been since early 2009. Furthermore the gap between macro and the S&P 500 has never been greater.
The central banks have separated markets from fundamentals to a remarkable degree. However, this deterioration in economic fundamentals and the prospect of declining earnings and revenues this year must make the Federal Reserve a little nervous. This recent statement from Yellen seemed to recognize that their could be limits to the ability of the Fed to set all prices all the time.
“It is sobering to note that many market participants appear to assess the risks to the outlook quite differently,” she said. “Investors place considerable odds on adverse scenarios that would necessitate a lower and flatter trajectory of the federal funds rate than envisioned in [Fed officials’] projections.”
Some additional help may be needed to keep the game going. Certainly any further rally in the US Dollar could cause challenges they would rather not have to deal with. The Fed has already talked uncharacteristically about the dollar in recent statements, but it is unlikely that much more can be said particularly while the IMF discussions on SDR quotas continue over the summer. These discussions are already likely to result in a lower profile for the dollar as a world reserve currency, as this is the main issue central to these discussions.
The bottom line is that the recent weakness of the dollar is not only technically significant as a potential change in trend, but the policy backdrop may also align with an acceptance of at least a temporary cap on any further US dollar gains.
A change in the trend in the dollar could significantly alter the trends for US investors in favor of non-dollar equities and commodities in particular. These sectors have in general only had a minor recovery so far and so the opportunity in these areas could now be much greater than in US stocks. Finally, the headwind may have stopped while the relative value has improved significantly relative to a year ago.