Much of the Good News is Already Priced Into the U.S. Dollar, says Scotiabank

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- USD is probably peaking as strong data now priced-in

- GDP had ‘deficiencies’ and Fed is likely to stay neutral

- Swap demand for USD high and is a positive factor

The U.S. Dollar may struggle to make further gains despite strong economic data including a consensus-busting GDP figure last Friday, according to analysts at Scotiabank, who say most of the ‘good news’ about the economy has already been priced into the greenback.   

“While the USD looks poised to remain strong, we are still of the opinion that USD gains are looking stretched – the good news is priced in and investors and speculators have the position on,” says Shaun Osborne chief FX strategist at Scotiabank.

On the surface, the 3.2% first-quarter increase in GDP revealed last Friday looked like a strong number however, a further investigation of the underlying detail reveals “deficiencies according to Osborne.

Much of the first-quarter growth was down to an increase in business inventories, while the more relevant consumer demand component was relatively soft, Osborne says. Inventories are manufactured products that are yet to be sold and an inventory build-up is sometimes an indicator of decelerating demand.

“The pace of growth is not sustainable and underlying inflation data looked soft” Osborne writes, in a note to clients.   

Indeed, the fact the U.S. Dollar slipped lower after the release on Friday, in what looked like a classic ‘buy the rumour sell the fact' trade dynamic, could suggest the market thinks its already paid for all of the good news likely to emerge from the U.S. 

The issue is even more relevant in the run-up to the Federal Reserve (Fed) policy meeting on Wednesday, where the Fed will decide whether or not to change interest rates based on its latest assessment of the economy.

If rate setters decide the economy is at risk of overheating, and inflation likely to rise above the 2% target, they could decide to raise interest rates to counter those developments but Scotiabank's Osborne and other analysts say that's unlikely. 

This is key to the Dollar since higher rates tend to strengthen currencies while lower rates tend to weaken then. This is because higher rates tend to attract greater inflows of foreign capital drawn by the promise of higher returns, and this increases demand for the local currency.  

The Fed has been lifting its interest rate since the final quarter of 2015 although many argue that it's now announced all of the rate hikes that it's likely to, while some are contemplating the odds of interest rate cuts before the year is out.

Interest rate cuts in either 2019 or 2020 are becoming a consensus view as many economists expect the U.S. growth to slow rapidly this year, although the Fed has so-far adopted only a neutral interest rate stance and says it's policy outlook is ‘data dependent’.

Although the strong GDP result was initially said to be something that might encourage the Fed to shift its stance, the Fed is likely to remain in 'neutral' mode from here onward according to Scotiabank. 

This means the Dollar could struggle to advance any further than it already has done, although it does not necessarily mean the greenback will decline any time soon either because markets currrently have an insatiable appetite for Dollars even if there isn't an obvious reason for why. 

"We can acknowledge that certain data points (EUR cross currency basis swaps) do reflect some tightness in USD funding which may reflect in the USD’s performance so far this year – and suggests that demand for the USD remains elevated even if the reason for the apparent demand for USDs is not clear," Osborne says.

The U.S. Dollar index was -0.33% lower at 97.52 on Tuesday but has risen 1.56% thus far in 2019. It rose more than 4% in 2018, after completely reversing what was once a -4% loss for the first quarter of that year.

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