Q4 Outlook: USD going down one way or another
Head of FX Strategy
Summary: This policy mix almost guarantees that we are set firmly on the path to the return of inflation, and likely stagflation.
If the Fed won’t kill the dollar, Trump will be happy to lend a hand
We have been trying to call the US dollar weaker this year, with the caveat that the path might prove difficult as the Fed would have to get ahead of the curve — which it has thus far not been able to do. Market expectations are that the Fed’s policy path will remain largely unchanged from where they were a quarter ago, and there is increasing evidence that the Fed may not have the tools – or more importantly the will – to get ahead of the curve. Enter the Trump administration, which is likely set to pull out all of the stops.
After the realisation that hiking policy rates in cratering markets in December 2018 was a policy mistake, the Powell Fed’s subsequent turnaround and easing has proceeded at a sedate pace. That, even after the initial shocking reversal in rhetoric in admitting the policy mistake in January of this year.
Indeed, while two 25 basis point Fed rate cuts are in the bag from the July and September FOMC meetings — and at least one more is priced for Q4 — USD liquidity and funding issues in the US banking system have become so dire that the Fed was forced to launch a large overnight repo operation the day before the September FOMC meeting in order to maintain control of funding rates. This is a major crack in the Fed’s credibility and effectively tips the market off that it is losing control of its balance sheet.
The fact that this issue could sneak up on the Fed so easily should be of concern, hinting that the central bank could remain slow in responding to further USD liquidity issues. At the September FOMC meeting, Chair Powell suggested an ad hoc or TOMO (temporary open market operations) approach to dealing with funding pinches like those that led to their September repo operations, rather than immediately opening up for the idea of POMO (permanent open market operations, or essentially QE) just yet.
The main force driving US dollar’s liquidity/funding issues is the mounting difficulty the US is having in funding its current account deficit. This is driven by the twin trade and Trump deficits — the latter having ballooned to a $1 trillion-a-year clip under Trump’s tax cut regime.
As foreign central banks have lost their ability to, and interest in, accumulating USD reserves, the funding for these deficits has largely shifted to domestic sources. US savers’ and US banks’ balance sheets simply can’t absorb the torrent of issuance. Something has to give, and that something will be the Fed: whether it wants to or not.
So far, the Fed has proven too cautious to get ahead of the issue. But in Q4, it is likely that they will be forced to respond in ever larger amounts to further liquidity provision. More importantly, the Trump administration may wrest control of policy, as suggested in Steen’s piece in this Outlook.
Its lofty talk of political independence aside, the Fed cannot entirely avoid politics. And going full in on resuming balance-sheet expansion to control policy rates acts as a powerful endorsement of Trump administration deficits, something it is not likely happy about. Let’s not forget former NY Fed Governor Dudley’s speech in Q3 telling the Powell Fed to stick it to Trump to ensure that he is “enabled”.
A heel-dragging Fed and dark clouds gathering over the economic outlook almost ensures that the Trump administration will be scrambling for the funding it needs to ensure Trump’s re-election in 2020. Ironically, after a quarter in which the entire world fretted the risk of perma-deflation, this policy mix almost guarantees that we are set firmly on the path to the return of inflation, and likely stagflation.
Outlook for selected currencies:
EUR – it was clear at the ECB’s September meeting that the Draghi ECB era is over and that the central bank is at the end of its policy rope, because virtually all core EU country representatives on the Governing Council were against the resumption of QE. We like EURUSD significantly higher as there is plenty of room for fiscal measures in Europe and new EU leadership in Q4 may well deal with the EU’s economic weakness.
JPY – USDJPY is another no brainer way to express USD depreciation if the Fed and/or Trump get ahead of the USD funding issues – looking for a move to 100.00 and possibly lower.
CHF – the SNB mobilised its intervention policy to ease the franc’s ascent, but the sense that the ECB is done for the cycle after the September meeting may mean there is little further pressure on the franc to appreciate versus the single currency. Especially as any EU existential concerns seem banished for some time now by the awkward new Italian coalition.
GBP – We don’t even pretend to have a crystal ball here. Brexit questions are at a point of maximum uncertainty as Q3 draws to a close. At some point, either elections or a second referendum would seem necessary, but a hard exit on October 31 can’t be ruled out. Either way, further delay will do the UK no favours, as the credit impulse suggests an ugly recession baked into the cake for the UK in the coming quarters. Caution is advised.
Smaller DM currencies – these are the trickiest to assess in the coming environment. A weaker USD is a general relief to the global economy, but traders may have to pick their moments as we see strong risks of rising volatility. SEK and NOK look the most undervalued, with SEK possibly set to respond the most sharply if we see a switch to a fiscal approach to stimulus in the EU and/or Sweden.
EM and China – all eyes are on October’s talks between the US and China. Stabilisation is the best we can hope for, and a weaker US dollar eases China’s USD funding needs as well. But EM currencies may be in for a volatile ride as USD weakness provides relief on the one hand while growth outlook concerns and rising market volatility apply negative pressure.