Currency Wars To Break Dollar?
The stronger dollar has caused defensive equity sectors to lead.
Seemingly many people out of nowhere are now bullish on the Dollar. After all, the Federal Reserve is winding down stimulus, desperately hoping to raise rates so that they have room to lower them again for whenever the next recession comes. Meanwhile, Europe is flirting with deflation, and central bank paranoia likely means the European Central Bank will attempt to juice inflation expectations. Traditional currency analysis would argue that when one country is reducing stimulus at the same time another is increasing it, the country reducing stimulus tends to see its currency appreciate on interest rate differentials.
The strong dollar has served as a drag on commodities clearly given that when adjusting for strength, dollar denominated raw materials become cheaper. This in and of itself is a disinflationary force, which may explain why low beta defensive sectors have been strong recently as our equity sector ATAC Beta Rotation Fund (Ticker: BROTX) remains positioned all-in defensively in the current environment. However, there likely will be concerns being expressed by Federal Reserve officials about Dollar strength should appreciation continue. Why? Because this would serve as a headwind against the Fed's attempts to increase inflation expectations, given that a strong currency tends to put downward pressure on domestically made products relative to cheaper imported goods. And the Fed likely will not be willing to go down easily as global currency wars take hold.
The fear of central bank jawboning might reverse strength in the Dollar into the end of the year. Take a look below at the price of the PowerShares DB US Dollar Index Bullish ETF (UUP) and notice that the ETF, which represents a basket of currencies, may be ripe for a turnaround just as new highs are reached. Over the past three years, it is at this level that declines have tended to happen.
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I know it sounds patriotic to want a strong Dollar, but when inflation expectations are already low, a strong currency can be damaging to domestic growth activity and potentially send the US into a deflationary environment. The Federal Reserve must know this, and as we've seen, words seem to be enough for markets to initiate new trends. I believe we may soon see this, which could for a short period of time dampen the Dollar's strength.
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