End of Cheap Money brings Equity Correction.
The dollar is set to continue its recent rally in the short term at least. The recent correction in equity markets driven by the prospect of higher inflation in the U.S. that could lead to a more aggressive period of rate hikes by the Fed. will drive the dollar index back towards 92.50.
The U.S. economy is starting to perform at close to trend as inflation returns following its disappearance as growth returns globally. Wage data was the catalyst for the seismic shift we saw starting last Friday although activity indexes have been picking up leading to an expectation for higher inflation as predicted by former FOMC Chair Janet Yellen. Her pre-emptive actions may be correct going forward as CPI starts to pick up.Jerome Powell is going to be faced with a more difficult decision than was first imagined as he will have to decide on interest rate hikes in advance of confirming data to avoid falling behind the curve and having to increase
both the rate and size of hikes.
The reaction of the dollar to changes in monetary policy both real and expected will be a primary driver of the dollar for, at least the first half of the year.
Eurozone to catch up quickly
However, as economic fundamentals become more established across the Eurozone, the common currency will recommence its march toward 1.3000. The Eurozone is coping well with a situation that is unique in global economic activity. There is no precedent for bringing nineteen diverse economies together under a single monetary policy. The task is made even harder by the nineteen retaining autonomy over their fiscal policy.
The reticence of ECB President Mario Draghi to act as he would were he to be the head of an individual nation’s monetary policy is wholly understandable. The pace of growth in each individual state depends on so many diverse factors that is almost impossible to set a cohesive policy.
The Euro has returned to familiar territory versus the dollar. The 1.23’s appear to be neutral attracting neither buyers or sellers. The correction may not yet have been deep enough to produce fresh highs once the rally commences and a test of the 1.2280 support remains possible. Buying should start again around 102180/1.2220 with a move through 1.2520 likely as
expectation of a normalization of monetary policy grow in strength.
Brexit concerns to push pound lower
The hope (it was never more than that!) that the UK could extract a favourable deal following a transition period for leaving the EU should have now been finally extinguished following the words of Chief EU Negotiator Michel Barnier who confirmed that the UK on the outside of the single market and customs union, would face trade barriers and tariffs. Since Theresa May
confirmed that the UK would indeed leave the single market and customs union, a
tough period of negotiation is now likely.
It seems Sterling has not even come close to pricing in a tough Brexit, but those expectations should become a major factor in the next major move for the pound.
As the economy founders and inflation remains frustratingly high, the hand of the MPC are effectively tied, a necessary hike in interest rates could push the economy in stagflation as prices continue to rise due to a weak currency as activity falls due to a lack of investment.
The pound has so far held its own in the face of a far stronger dollar although now it has fallen below 1.4000 a test to 1.3870 support is likely the common currency, the pound is set to break below 1.1000 as a return to normal monetary policy becomes more likely in the Eurozone.