Written in Feb 13th, 2017.
Cheap U.S. dollar presents the opportunity to buy in, waiting for another grand bull market trend to reappear.
US Dollar Index will reach a new height since the recession.
In the course of the past two years, as United States ended the QE stimulus programme and started the rate-rising cycle, US Dollar Index has begun its long-term bull market trend. However, since the market fluctuates rapidly, if investors fail to trade in the right moment, starting to move along with the market atmosphere, it would often end up chasing for nothing. On such note, it is pleasing to see that over the past two years, we have pointed out in June 2015 and July 2016 that the right timing for buying US dollars (see chart 1). And by reviewing the outcome, our strategy is spot on. In this article, we are to inform you that after the correction happened at the beginning of this year, US Dollar Index is now showing an excellent opportunity to invest, and this time the gain will be significant.
Chart 1. The red circles show the timing when we predict longing U.S. currency over the past two years, providing investors decent returns. Unit: index Source: Marketwatch
Why is the upcoming quarter the perfect opportunity to invest in US dollars? There are three major factors based on the economic fundamentals that will lay out a great chance to buy in at a lower price.
A. The trading statistics indicate that US dollars will go weak then strong.
Chart 2. U.S. imports (blue) vs exports, imports is speeding up faster than exports. Unit: index Source: FRED
As the US and global economy are starting to expand prominently, the status of US import and export keeps getting better (see chart 2). Specifically, the import numbers are showing a great acceleration. It suggests that besides the increasing actual needs that contribute to the numbers, there are other factors at play! What is the cause of it? Basically, it is related to the Border Adjustment Tax that President Trump and Republican congress are beginning to discuss. The new tax bill is going to charge all import goods a 20% import duties (the tax rate is undetermined; it resembles other countries’ import value-added tax), and duty free for export goods. The bill will be going through the legislative process approximately this spring; therefore, companies with import business will begin to increase their imports as early as possible, in order to avoid the impact of the new tax bill. And due to the recent spike of sales in US, the inventory level has come to a new low point of the last two years. Thus, the increasing needs for import goods will become more apparent in the next six months (see chart 3).
Chart 3. U.S. inventories to sales ratio: steadily improved in last year, companies worked hard to digest inventories. Unit: % Source: FRED
Under such circumstances, since that current account is the key element to determine the long-term trend of exchange rate, during this short period of expanding imports of goods, US dollars will suffer from certain pressure, and also affecting the trend of other currencies. However, making early expansion of imports still has a limit. As the details of the new policy settled, and putting in motion in the 4th quarter this year (new fiscal year in 2018) to next year, such increasing needs for imports will be replaced by another cycle of dealing with inventories. Then, the whole trading trend and other non-US market’s exports needs will be reversed, or even emerges a bigger need gap. Then, the US trade deficit will significantly decrease, and so will other countries’ trade surplus, which would lead to US dollars appreciating to a new height.
B. The inflation statistics indicate that US dollars will reach the bottom and bounce back.
The second factor that the US dollars will gradually reach the bottom and start to bounce back is the trend of US inflation. It will significantly affect the interest rate of US in the future, and also affect the possible trend of US dollar Index. The numbers of inflation are relative, which means that the inflation numbers of US should be compared to other major corresponding countries. And looking from US Dollar Index’s point of view, it would be the trend of Inflation in the euro area. We can see in chart 4, since 2011, the numbers of US inflation usually are better than the ones in euro area. In that case, the US currency strategy comparing to euro area is rather tighter in a long term period. This is also the reason that the bull market of US dollar has continued for six years.
Chart 4. Trade weighted U.S. Dollar Index (blue) vs Harmonized Index of Consumer Prices in Euro area YOY (red) vs Consumer Price Index YOY in U.S. (green) Unit: index, %, % Source: FRED
And the most important reason causing the recent euro bounce back, and the US Dollar Index setback, is because of the inflation in euro area has started to warm up. In December, the level of inflation has reached a new height of 1.1% in the last three years. As the base period is lower, the level of inflation in euro area can maintain at 1-1.5% in the first half year. It is safe to say that the deflation crisis of euro area is relieved momentarily. As to the reason that the inflation level can rise in euro area this time, besides from its own gain of economic recovery, a great deal is contributed from the rising oil price and strong US currency. Since the rising price of commodities affect the inflation in both US and euro area, the rise of inflation level in euro area is greatly contributed by the strong US currency. In other words, US currency needs to stay strong, for euro to have the capacity to continue improving through inflation, and in the longer future, has the chance to shift the currency policy and stimulate the euro to appreciate. Yet, this scenario still needs time to accumulate to realize, and it will not take place in this year at least.
Why? The main reason is the new policy of custom duties of Trump government we mentioned above. It will not only greatly increase the imports price level, but also increase the price of domestic commodities (since oil and commodities imports currently do not seem to be duty-free). This will heat up the possible gradual inflation in the later half year that benefits from low base period. Then, combining with a booming employment market, tax cut and expanding infrastructure constructions all in motion, the inflation level and interest rate of US will significantly increase and accelerate, and pushing the US dollars to appreciate.
C. US economic growth is still better than other major countries.
Chart 5. U.S. GDP YOY (red) vs Euro area GDP YOY (purple) vs Trade weighted U.S. Dollar Index (green) Unit: %, %, index Source: FRED
The last key factor that will affect global currencies and capital movements, is the economic fundamentals. We can see in chart 5, Trade Weighted US Dollar Index in the past twenty years has gone through two bull market and one bear market cycle. The most important factor relating to this, is that after European Union expanded east, there was a rapid growth in euro area in the beginning of this century, and US Dollar Index is also at a relatively high position. Then, the decline kept moving downwards, until after the recession in 2008. After the recession, due to the European debt crisis and the new emerging European market began to stale, the economic growth of euro area started to fall behind US.
What about the future? Although the economic growth in the euro area last year (2016) finally surpassed US in the past ten years (1.7% vs 1.6%), US Dollar Index also began to go weak in the start of this year, this is not a shift of the long term trend. As shown in chart 6, in the first three quarters of last year (the statistics of the 4th quarter is not yet announced when this article is written), the needs of exports (first chart to the left) has been a great help. Even though the domestic needs in the euro area has increased, it is roughly the same as the recovery base period since 2014. And last year, the private investment and inventories in the euro area for the first three quarters are pretty weak. This circumstance is very different from US, for its economic growth is basically all supported by the private consumption (see chart 7). Last year, the increase of domestic needs in US is doubled than the euro area. The increase of domestic needs is the most important factor of whether the local economy can maintain a long term expansion. In other words, the prominent economy performance last year in the euro area, or to say that the euro area can recover and start heating up the economy, the weak euro currency leading an increase in exports needs is notably the great help.
Chart 6. Net exports to GDP (left) , Private Consumption Expenditures to GDP, Investment and Inventories to GDP Unit: % Source: FRBNY
Chart 7. U.S. Personal Consumption Expenditures: supporting the entire GDP growth Unit: % Source: FRBNY
Obviously, due to last year’s lower base period of private consumption and investment in the euro area, it should be doing rather well this year. However, the base period of US private investments and inventories is also pretty low, and should be doing pretty well this year. Overall, the euro area still relies on the increase of exports needs, and the benefits of lower base period, thus, the trend of surpassing US economy growth might just be a spark in the pan (the numbers still need to be confirmed and finalized as well since the US GDP in the 4th quarter and last year might have a small increase). This year, US will still beat the euro area in economic growth at about 0.5%-1%. Thus, the bull market trend for the US currency will maintain its course.
Investing timing: seize the moments before the 3rd rate rise and invest separately.
Due to the early imports trend in US, that ignites the market sales and early consumption sales, the price of commodities in the market will rise, and eventually resulting the booming capital market in US and the globe, and heat up the trend of inflation. Thus, whether there would be a rate rise in March or not, it is certain that there will be a third rate rise in the first half year. According to the experience in the past three years, three months before the announcement of major currency policy is the best time to buy in US Dollar Index. The three time period are listed below (can also see chart 8):
- October 29th, 2014, US ended the QE stimulus programme (the end of currency easing cycle).
- December 16th, 2015, the first rate rise for the past ten years in US (the start of currency tightening cycle).
- December 14th, 2016, the second rate rise in US (confirming the currency tightening cycle).
The three time periods are the green circles in the chart below. The purple circles are the periods three months before the according rate policies, which are the best timings to long the US Dollar Index.
Chart 8. U.S. Dollar Index chart in the past three years: three months before crucial decisions are the best timings to buy in. Unit: index Source: Stockcharts
Simply put, investment is to buy at the expectation and sell at the realization. When rate rise is a reality, and everyone is optimistic about US currency, and not so excited about euro and emerging markets currencies at the start of this year, US currency began to depreciate, and euro and emerging markets currencies are doing rather well. And when the public starts focusing on markets outside of US and emerging markets’ increasing economy growth, and neglects the possible impacts of the next rate rise, it would then be a good timing to start invest in US Dollar Index! Besides the US Dollar Index will have a steady position in the upcoming quarters, as the influence the rate rise sets in, it will cause the capital market and emerging markets currency certain amount of pressure. Therefore, you can long the US Dollar Index at a lower price at the time period we have suggested in the past two years, you should also do the exchange of other currencies (including US Dollar Index currencies, CNY, NTD, and emerging markets currencies) to US currency in the second quarter, in order to avoid the depreciation risk resulted from the rate rise cycle each quarter in the US.
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