The US dollar’s selloff accelerated. It has been selling off since the start of the year. The first phase of the decline at the start of the year seemed similar to what happened at the start of 2016. Following the Fed’s first-rate hike at the end of 2015, the dollar weakened in the first several months of 2016. Disappointing economic growth, deferred expectations for another hike, and position adjustments were the key drivers. Similarly, the dollar traded heavily at the start of 2017 after rallying strongly in H2 2016.
The second phase began in late April. Recall that the fear at the start of the year was that the populist-nationalist wave that was said to have been behind the UK decision to leave the EU and the Trump’s victory in the US was going to sweep across Europe. The dollar’s consolidation of the first part of the year ended abruptly when it became clear in late April that the National Front was going to be defeated. Indeed, the euro gapped higher in response and has not looked back.
The shortage of dollar that was evident in its rapid appreciation and the extreme premium for dollar’s in the cross-currency swaps eased dramatically. It appeared to partly be a function of the US Treasury Department drawing down its cash balances at the Federal Reserve as it maneuvered after the debt ceiling that had been hit.
The third phase was seemed to be a function of a mini-convergence wave. The eurozone experienced an inflation scare around the same time as it became clearer to investors that despite a Republican in the White House and a Republican majority in both houses of Congress, the legislative agenda tax reform, deregulation, and infrastructure that was to boost the growth potential of the world’s largest economy was unlikely to be delivered. The eurozone inflation spike sparked speculation that the ECB could hike the negative 40 bp deposit rate before the asset purchases were completed.
US headline and core inflation trended lower starting in February. It did not prevent the Fed from hiking in March and June. However, the yield curve flattened as the long-term yields fell more than the short-end. Most recently, yields continued to fall as the business wing of the Trump’s coalition peeled away following Trump’s controversial response to White Supremacy incited violence. Cohn, the President’s chief economic adviser, was the odds-on favorite to succeed Yellen when her term as Chair of the Federal Reserve ends early next year. However, his mild and belated criticism of Trump appears to have been seen as a sign of disloyalty, and appears to have taken him out contention.
Meanwhile, Cohn, whose chief task apparently was to draft a bold tax reform program fell out of favor. By late August it was clear that this was not going to happen. The White House retreated and returned the initiative, outside of some broad principles, including the jettisoning of the controversial Border Adjustment Tax. The fractured nature of Congress does not make investors particularly confident in the process or outcome. The weak price impulses, and the soon changing composition of the Federal Reserve has prompted the market be skeptical that rates will rise again this year or next.
Two anomalies about the dollar’s accelerated decline
First, even though the market does not expect the Fed to hike rates, it is convinced that the Fed will begin allowing its balance sheet to shrink starting in Q4. It begins slowly to be sure, and it will take place with the sales of a single instrument. It simply won’t reinvest the full amount that is maturing. The ECB made it clear last week that it is no hurry to exit its extraordinary policies. It is not convinced that inflation has yet to enter a sustainable and durable path. This suggests that the ECB’s balance sheet is likely to expand by more and for longer than may be appreciated by market participants, many of whom are concerned that the ECB will run out of assets it can buy under the current self-imposed rules.
