A Currency For All Seasons

John Leiper – Chief Investment Officer – 9th August

Having identified, and benefited from, the 7% fall in the value of the US dollar index since late April, we have now turned tactically cautious.

Since breaking through its 10 year support line, in white, the index has twice tested support at 92.5 and now formed a ‘doji’ candlestick pattern for the week. This pattern is comprised of a small body and long wicks and typically signifies indecision between bulls and bears. It is usually found at the bottom of trends and can be associated with a possible reversal of direction.

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This is consistent with the latest reading from the relative strength index which puts the US dollar index into oversold territory.

Prior instances, identified by the yellow arrows, are consistent with a subsequent rebound in the value of the US dollar, typically lasting several months and usually within the existing longer term trend, be it lower (such as the downtrend of the 2000s) or higher (throughout the subsequent decade).  

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Setting aside the technicals, one fundamental reason why the US dollar could recover from here, is liquidity.

As detailed in Don’t Fight The Fed (26th May 2020), throughout March and April, the Fed massively outpaced the Treasury, by buying more bonds than the Treasury issued, ensuring liquidity was plentiful.

However, over the last two months, in a reversal of roles, the US Treasury has out-issued the Fed, resulting in a reduction in US dollar liquidity in the commercial banking system. This is demonstrated in the chart below by the fall in the blue line on the far right hand side. The US dollar is highly correlated to this measure of liquidity, which may lead to a stronger currency over the coming months (right hand axis is inverted).

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The main reason for the drain in liquidity is the accumulation of cash held in the Treasury General Account (TGA) which has now reached 1.8 trillion dollars.

Treasury Secretary Steve Mnuchin undoubtedly plans to deploy these funds and is working on the assumption that the cash balance will fall to $800 billion by the end of Q3. However, that was also the plan for the end of Q2. Meanwhile, congressional leaders remain far from a coronavirus relief deal and President Trump’s executive action, announced over the weekend, will likely prove ineffectual. Should TGA cash levels remain elevated over the near term, this could bolster the dollar as described above.

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A stronger US dollar would not necessarily run contrary to Donald Trump’s political ambitions as evidenced by the close correlation between the currency and probability of electoral success as forecast by PredictIt.

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Then there are seasonal factors to consider. The US dollar is heading into a seasonally strong period with average gains, over the last ten years, of 0.3% in August, 0.2% in September and October and 1.7% in November.

This seasonality coincides with the presidential cycle. Over the last 30 years, during which time there have been seven presidential elections, the US dollar has rallied approximately 3% in the 50 day run-up to election day.

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Whilst the likelihood of a technical bounce in the value of the US dollar is high, we remain strategically bearish over the medium term. Key drivers include the surge in the money supply, high debt levels and expectations for further easing resulting in lower for longer nominal interest rates and rising inflation expectations. Low fx hedging costs will also weigh on the currency over time as hedge ratios rise globally.

Turning to the UK pound, the catalyst for the move higher in GBP/USD at the end of July was Michelle Barnier’s comments, in a closed door meeting, that a trade deal with the UK was likely. We believe fears of a no-deal scenario are overplayed and retain our medium term forecast for 1.40 to 1.45 versus the US dollar. However, this remains the big outstanding hurdle and an ongoing source of volatility over the coming months.

On a near-term basis the concern is that the aforementioned rebound in the US dollar could translate into GBP weakness. One positive development came on Thursday from the Bank of England’s MPC minutes which forecast that that the economic slump would be less severe than previously expected whilst downplaying the role of negative interest rates. This will likely prove short-term supportive and it was reassuring to see GBP/USD initially rise towards 1.32.

Over the last few days we have seen two attempts to break higher and three attempts to move lower, all of which have failed. Next week could prove eventful with second quarter GDP data alongside industrial production and a labour market report all of which have the potential to move the needle.

 

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This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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