US dollar strength continues to confound in face of QE Infinity…

Since the turn of the year, and against analysts’ expectations (once again!), the US dollar has been rising against all the major currencies. The Yen and the Pound are the major losers against the greenback but the dollar’s gain is broad-based against pretty much every other pair. With the US equity market rising 10$, why is the dollar rising as well when there is typically a negative correlation? For overseas investors in the US equities, the dollar strength is providing an extra boost to their returns as the US dollar buys more of the domestic currenct. Is the dollar the new gold given the yello metals poor performance this year?

There are several arguments both in favor and against the dollar at present. On the negative side, pushing for a weaker US Dollar we have at least two factors. One of them, as we already referred to above is the rise in equities. The reduction in risk sentiment evidenced by the falling VIX and rising risky asset prices like high yield bonds and small cap equities, typically puts downwards pressure on the dollar as investors look for riskier assets. The other important factor relates to “QE infinity”. With an aggressive asset purchase program amounting to $85 billion a month and a commitment to perpetuate it until unemployment hits 6.5%, inflation expectations should be rising and with it and, so according to conventional economic theory, consequently the dollar falling.

On the positive side pushing the US dollar up, we have at least three main factors: first of all, in the global currency war stakes, in which central banks are trying all methods they can to depreciate their currency relative to others in order to boost exports and the likes of Japan are being more aggressive than the US; secondly, economic data in the US has been clearly improving and which is creating some dissenting voices within the FED with regards to the wisdom of maintaining the QE programs (a sentiment we have sympathy with and as set out in out Q1 guide at the foot of this piece. Finally, the European, UK & Japanese economies remain in low gear relative to the US and so interest rate differentials are likely to rise here on a 6-12 months view given the current relative economic trajectories.

If we look at central bank activity, we can partially understand the basis behind the stronger than expected dollar. It is true that the FED is also a participant in the currency war through its QE program but other major central banks have joined the party. The BOE is expected to raise its asset purchase program once Canadian Mark Carney takes the helm and Mervyn “the swerve” King continues to make ill advised comments about the  overvalued Pound and which have been working like a charm to bring it down. Meanwhile the BOJ is fighting to create inflation with radical new economic policies under new PM Shinzo Abe. The debasement of the wildly overvalued yen continues in earnest allowing the Japanese to regain competitiveness against their Asian bloc peers. Even the ECB has began using a verbal policy in recent weeks to try to avoid too much appreciation for the Euro.

In terms of economic data, the evolution of Non-farm payrolls in the US over the last 12 months has been very positive. The average gain in payrolls has been around 164,000 and there is no record of a negative month since Sept 2010. The unemployment rate is now sitting at 7.7% whilst in August 2010 it was 9.5% and even just one year ago it was 8.3%.

I was over there on business just last week and in speaking with a variety of business individuals and reading the newspapers/watching the news, it is apparent that there is a new found sense of optimism and pick up in activity after 5 long years of depressed activity.

In contrast, here in the UK, we appear to be heading towards a triple dip recession, albeit of a narrow dip. Within the Eurozone there is still a battle amongst its leaders as to whether austerity should go deeper or if certain countries like Spain & Italy should adopt more expansionary policies. With the entire eurozone’s unemployment surpassing 11% (and around 20% in many single countries) and with negative GDP growth, the dollar is a ray of sunlight for international investors.

The main economic blocs ex US and China aren’t growing at all and continue to experience problems which are largely brought about through austerity, while the US is much better positioned, ironically due to the lack of austerity as evidenced by the mere tweaking at the margins with their public spending.

With expectations for growth being more positive in the US, and the future interest rate differential only likely to rise and QE’s ceasing now on the horizon, then the dollar is likely to continue its strong showing. We could be setting up for a dollar squeeze higher of epic proportions.