The Indicators Suggesting the Dollar's Run Higher is not yet Complete

- - Fiscal stimulus and heightened trade risks increasingly bullish for USD

- Fallout of increased protectionism could further enhance inflation and push up interest rates

- Charts point to medium-term strength for USD versus commodity block counterparts as tariffs bite

Image © Daniel Sky Photo, Adobe Stock

We are seeing increasing evidence to back a medium-term bullish forecast for the US Dollar.

Despite recent US inflation and wage data in June disappointing, the broader thrust for both metrics remains to the upside.

Indeed, inflation data in June still rose by 0.1%, just not by the 0.2% expected; the annual rate also continued to rise even further above the Fed's target of 2.0%, reaching a new high of 2.9%.

It could be argued that some slowdown in inflation was to be expected in June due to the influence of higher interest rates and a stronger Dollar.

Rising inflation tends bullish for the US Dollar when accompanied by economic growth as it leads to higher interest rates at the Federal Reserve which in turn tends to attract greater inflows of foreign capital from investors looking for somewhere lucrative to park their capital.

Growth and inflation in the US is likely to continue rising from two primary sources: increased fiscal stimulus from Trump's tax cuts/reforms and inflation from the imposition of tariffs on a wider array of Asian manufactured consumer goods.

A further possible source is the possible reversal of the process of globalisation via the Trump administration's penchant for tariffs, which economists say could lead to a structural return of inflation to globally competitive sectors such as electronic goods and cars.

A possible reversal of years of devaluation in these sectors and rapid re-calibration to a more protectionist world order could lead to a sustained inflation spike. And economists are actually suggesting this could be a financial stability risk.

It is the efficiency that drives cheaper prices and raises the standard of living for US consumers that is actually most at risk of a trade war.

'Walking-back' circa 20 years of globalisation and free trade will reduce global competition leading to higher prices - as without the threat of Asian manufacturers producing goods for a fraction of the price US manufacturers can produce them at, prices will rise, increasing inflation all around.

For more on this we recommend highly that you read our piece from earlier in the week covering a chart from the EIA which shows a gorge-like divergence between the prices of tradable and non-tradable US goods and services since 1997. 

"If Donald Trump succeeds in upending the global trade order, he could end up reversing the dynamics that have driven down the cost of tradable goods for decades," says a note covering this chart on the economics blog The Heisenberg Report.

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Fed Could Raise Rates Beyond 3.5%

Higher inflation expectations will in turn likely lead to higher interest rates at the Federal Reserve.

Interest rates are currently expected to reach a peak level of 3.5% this cycle which is now not too far away from the 1.75-2.00% existing rate. Assuming the above twin drivers of inflation and growth, however, and we see possibility of the terminal rate rising well above 3.5% eventually when cost of goods inflation starts to feed through.

Trump's fiscal stimulus policies also seem to be driving unnatural levels of growth in the US, for now, at least according to Gabriela Santos a cross-asset strategist at JP Morgan, who said in a recent interview with Bloomberg News that she saw growth coming out at 5.0% in Q2.

Whilst her conclusions may differ from the view being put forward here, Santos still sees growth peaking from the Trump fiscal stimulus "sugar high" in the short-term.

After that, however, she sees US growth decelerating and the US Dollar with it.

"Perhaps we have some more of that fiscal stimulus, sugar high, for the next 12 months but then that starts to fade and interest rates start to bite a bit a little more. So really the perspective for the US surge is very short-lived, so that is something that should start wearing out whilst the rest of the world starts picking back up," says Santos who holds a bearish US Dollar view in the medium-term.

Although it will be difficult for growth to continue rising at the sorts of levels quoted, JP Morgan's analysis does not take into account the impact on inflation of widespread tariffs, as well as their potentially negative impact on the rest of the world (RoW). There are nations much more reliant on exports than the US which exports relatively little and these will be hit the hardest by a global trade seizure.

In the JP Morgan analysis growth in RoW grinds higher and starts to converge with the declining US growth curve. Yet there is a risk RoW will decline too.

Technicals Arguing for Another Impulse of Dollar Strength

Yet our medium-term bullish view of the Dollar is not solely based on fundamentals, it is also informed by the technical outlook for many USD pairs on the charts.

We have noticed an increasingly bullish bias towards greater USD strength in many US Dollar pairs.

A recent Elliot Wave analysis of AUD/USD suggests declines to 0.68 are in the offing, and USD/CAD has broken out of a long-term channel generating an upside target back at the 2016 highs of 1.46. These are both compelling medium-term forecasts.

It is interesting to note that both these forecasts suggests out-sized gains the the US Dollar versus the commodity block of currencies. This seems to support the possibility of a ratcheting up in trade protectionism which will hurt the Canadian and Australian Dollars the most.

It further suggests that worsening global trade will be a major theme in markets.
Not only is this likely to lead to higher tariffs and a breakdown in globalisation as stated above, but more immediately it will increase safe-haven flows to the US Dollar as investors seem increasingly to prefer placing their money in US Treasury Bonds for safe keeping.

Indeed, this is borne out by evidence from the most recent bout of trade conflict between the US and China after Trump widened tariffs to incorporate $200bn of Chinese imports.

The Dollar actually rose versus the Yen on the news despite the risk off tone of the markets and the Yen's propensity to rise during global crises. The message was clear, the Dollar is back in the driving seat as the world's premier safe-haven again.

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