U.S. Dollar Treads Water as Government Shutdown Set to Roll On

- USD pares gains amid government shutdown, month-end flows.

- And analysts say it could cede further ground over coming days. 

- 2019 to bring a reversal of 2018 gains as Federal Reserve pauses.

The U.S. Dollar pared earlier gains Thursday to trade lower against most of its major rivals in a move that analysts say was driven by month-end porfolio rebalancing among investment managers.

America's greenback had risen sharply alongside stock markets Wednesday, although analysts say the move had little to do with economic fundamentals and that strength is likely to fade away ahead of the weekend.

The upward move came mid-way through a week that has seen the U.S. government shut down for the first time since 2013 after lawmakers were unable to agree a bill to keep the public sector funded due to a dispute over President Donald Trump's demands for funding to enable the construction of a wall along the Mexican border. Government agencies are closed and workers furloughed in order for the Treasury to conserve cash. 

Some analysts say the government shutdown could potentially go on until the middle of January and that U.S. economic data is unlikely to be released so long as public agencies are closed, although the disruption is not expected to impact on the economy itself. The Dollar may have been boosted Wednesday by a Bloomberg News report suggesting fresh trade talks between the U.S. and China will take place in early January.  

"It is likely that the move yesterday was not representative of positive broader fundamental sentiment and that there may be some reversals on profit-taking. If significant portfolio rebalancing, however, still needs to be done by the end of the year we could see some continued positive near term performance for the US dollar and equities into the close," says Fritz Luow, a currency analyst at MUFG.

Wednesday and Thursday's price action also came as markets weigh the implications of President Trump's latest criticism of the Federal Reserve. Trump has lashed out repeatedly at the central bank as well as its chairman Jerome Powell in recent months over its policy of gradually raising U.S. interest rates, saying the policy will harm the economy. A White House official claimed Wednesday that Powell's job is not in danger.

The only problem our economy has is the Fed. They don’t have a feel for the Market, they don’t understand necessary Trade Wars or Strong Dollars or even Democrat Shutdowns over Borders. The Fed is like a powerful golfer who can’t score because he has no touch - he can’t putt!

— Donald J. Trump (@realDonaldTrump) December 24, 2018

The U.S. Dollar index was -0.22% lower at 96.78 Thursday after having risen as high as 97.12 in the previous session. It is up 4.8% for 2018. 

The Pound-to-Dollar rate was quoted -0.09% lower at 1.2635 during noon trading and is down -6.4% for 2018. The Euro-to-Dollar rate was 0.26% higher at 1.1389 but is down by -5% for 2018.

The Federal Reserve is central the market mood heading into year-end. Last week the U.S. central bank raised its interest rate to 2.5%, marking its fourth rate hike of 2018, but used its so-called dot plot to signal that it will raise rates on only two occassions next year.

That could mark a turning point for the Dollar because it is divergence between interest rate policies in the U.S. and rest-of-world that has driven the greenback to from strength to strength in 2018. 

"The Fed has turned more datadependent on any further tightening, reflecting our prior view that interest rates were close to neutral. With that shift, we revised our 2019 Fed call to only one hike, one to be reversed on a cut in 2020," says Avery Shenfeld, chief economist at CIBC Capital Markets. "Look for earlier USD gains to be more significantly reversed in the second half of 2019 when markets will be looking ahead to the possibility of the Fed cutting rates on fiscal tightening in 2020."  

The Fed also slashed its estimate of the so-called long-run neutral rate from 3% to 2.75% last week. In English, this means policymakers are fearful the economy is less able to cope with higher rates than previously thought. That move came after nine rate hikes since the end of 2015, which are expected to begin weighing on the U.S. economy over the coming quarters. 

"While markets are anticipating limited Fed action next year, investors appear to be underestimating the odds of tightening by central banks abroad. Indeed, the end of QE in the Eurozone indicates that central bankers have not been deterred by recent soft data that we expect to prove transitory," says Shenfeld. 

Both the Bank of England and European Central Bank are expected to raise their interest rates again in 2019, generating support for their respective currencies relative to the U.S. Dollar. Shenfeld says this is likely to push the Dollar index down to 91.64 before the end of September 2019. 

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