BY DEB SHAW
- Following spectacular data in Q3, US economy squeezes out another good quarter
- Trump’s Iran sanctions drive up crude oil prices, sending inflation expectations higher
- Despite relative weakness in Q3, expect US dollar to begin rallying in earnest this quarter
In our previous commentary on the US dollar, we wrote that the buck was set to rise further thanks to our forecast for slowing US growth and inflation. Given the US dollar’s safe haven qualities, the currency performs the best when economic conditions deteriorate.
Following the publication of our last commentary, the performance of the US dollar index (a measure of the currency against major peers) has been mediocre. The index moved up from 95.10 on August 8 to 95.50 on October 3 – hardly a significant move. While we called for US growth to begin slowing last quarter, US economic data continued to accelerate instead. As financial markets have repriced expectations for Q3 growth in the US, the US dollar has been relatively weak as a result.
Going forward, we forecast that US growth and inflation will begin slowing this quarter (Q4 2018). In rate-of-change terms, the US economy has been accelerating since Q3 2016. Following 8-9 quarters of accelerating GDP growth (the longest expansion in recorded US history), the economy will face a combination of (1) a deteriorating slowdown in all major regions outside the United States, (2) steepening base effects, and (3) weakening drivers for continued growth. As the US joins the global downturn, expect the dollar to rise much further.
Spectacular US data = weak dollar
While the US dollar index surged towards 97 in mid-August, the rally has since run out of steam. The primary culprit is the continued outperformance of the US economy. Recent data including year-over-year retail sales, industrial production and durable goods orders have accelerated to growth rates not seen in many years.
Last month’s retail sales figures were particularly noteworthy, as domestic consumption makes up a significant portion of the US economy. While retail sales in August decelerated to 6.6% (versus 6.7% previously), July’s numbers were revised up by a significant degree. Recent trends in retail sales and industrial production are shown below:
US economic data at multi-year highs
US retail sales and industrial production are currently at growth rates not seen since the economic recovery that followed the global financial crisis in 2008. Industrial production growth was last seen at 4%+ in January 2011, while retail sales last grew at 6.7%+ in October 2011. Put another way, recent US economic data has been spectacular.
While the figures bode well for US GDP growth in the third quarter, year-over-year comparables are becoming much more challenging for the present quarter. These have been highlighted in red above. Retail sales growth is likely to decelerate as upcoming figures must contend with 5-6% growth in the past. In a similar vein, industrial production is also unlikely to keep growing on top of 3-4% growth at this point last year. As the biggest sectors of the US economy begin slowing, overall GDP growth is also likely to follow suit.
Crude oil curve ball drives inflation expectations
Beyond strong US growth data, US inflation expectations have also been higher than our prior forecast thanks to rising crude oil prices. Though most commodities (looking at the CRB index) have been selling off since June, crude oil prices are diverging from the broader asset class in a meaningful way. While global demand is increasingly suspect as Europe and emerging markets continue slowing (the key factor weighing on other commodities), crude oil traders remain squarely focused on supply.
As published in a recent edition of our daily crude oil update, we noted that concerns regarding Iranian exports continue to dominate price action. In May 2018, Iran exported the equivalent of 3% of global daily crude oil demand. As the Trump administration has taken a hard line towards Iran, the country’s exports have fallen much faster than expectations. OPEC has also been slow in responding to tightening supply, despite efforts from the Trump administration. As crude oil continues to make new highs (WTI recently made a new high for the year, while Brent recently strengthened to four-year highs), inflation expectations are rising accordingly. This is illustrated below:
Rising crude oil prices = rising inflation expectations
As can be seen above, financial markets have been ignoring the recent inflection in both year-over-year WTI (crude oil) price growth and the US consumer price index (headline inflation).
Going forward, we expect the combination of slowing crude oil prices (in rate-of-change terms) and steepening base effects to begin weighing on headline inflation this quarter. The increasingly difficult comparables (relative to last year) are highlighted in red above. While there is a risk to our forecast as crude oil remains in a bullish trend, the commodity would have to rise considerably from here to overcome particularly steep base effects.
While speculators are long the dollar, history suggests net positions can rise much further
As discussed above, the outlook for both US growth and inflation is darkening following improving economic data and a significant jump in crude oil prices last quarter. The last factor supporting a stronger dollar is speculator positioning based on data from futures and options exchanges. While speculators are now long the US dollar, positioning remains moderate when compared to history. An overview of net speculator positioning in the US dollar index contract (futures and options combined) is shown below for reference:
Long positions still moderate relative to history
As can be seen above, speculator positioning in the US dollar via futures and options contracts is moderate. In 2015, the net position was +80,000 contracts while the net position in 2016 was approaching +60,000 contracts. With only 37,000 contracts net long the US dollar index today, speculator positioning can climb much further.
Changing economic tides to lift the dollar
Following 8-9 quarters of accelerating GDP growth, the US economy is unlikely to extend its longest recorded expansion in history. While the last quarter beat our previous forecasts, most economic and financial market signals continue to suggest that the US dollar will keep rallying. This is especially the case thanks to supportive economic trends and only moderately bullish sentiment. For traders looking to go long the currency, we recommend buying the US dollar at the bottom-end of its trading range that we update daily.
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