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The dollar, the euro and sterling

By David Morrison  |  15/11/2018 15:39

The British pound slumped today as Theresa May’s Brexit plans met with fierce opposition. Meanwhile, the dollar continues to be in favour

Earlier today the British pound slumped over two cents against the dollar. UK Prime Minister Theresa May faced a barrage of opposition from her own ministers and MPs after she revealed her proposed deal for UK withdrawal from the European Union. At the time of writing there had been seven ministerial resignations since yesterday’s cabinet meeting with Brexit Secretary Dominic Raab and Department of Works and Pensions Esther McVey being the most senior. On top of this, it looks as if there are now enough Conservative MPs prepared to write letters to Sir Graham Brady, Chairman of the 1922 Committee, and trigger a vote of ‘no confidence’ in the PM. It’s a dangerous game trying to predict where sterling goes now, as direction is all down to politics and news flow which is more fluid and uncertain than ever.

The Dollar Index

Instead, let’s consider the dollar. At the beginning of this week the US Dollar Index broke above 97.00 to hit its highest level since June 2017. It subsequently pulled back a touch, but it does look as if momentum favours continued dollar strength. The Dollar Index is a widely followed measure of the dollar’s value against a basket of currencies, including the Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. But it is the euro which enjoys the greatest weight within the index at 57.6%. The Japanese yen comes next at just 13.6%.


Given the euro’s importance within the Dollar Index, we should see a straightforward inversion chart-wise when looking at the EURUSD chart. And we do. At the beginning of this week we saw the EURUSD fall to its lowest level since June 2017 when it came within a spitting distance of breaking below 1.1200. But in a mirror image of the Dollar Index the EURUSD subsequently bounced. The main fundamental driver for dollar strength is the belief that the Fed will continue to raise rates and reduce its balance sheet, boosting its appeal while reducing its liquidity. At the same time, the European Central Bank (ECB) is set to end its bond purchase programme next month. However, dismal growth number across the Euro zone suggest that the ECB is unlikely to be in any hurry to raise rates. In fact, some analysts suggest that the bank’s president, Mario Draghi, could leave office in October next year without ever announcing a rate hike.

Chairman Powell

Meanwhile, on Wednesday night Fed Chairman Jerome Powell gave a speech followed by a Q&A session at the Dallas Federal Reserve. Mr Powell reiterated previous comments made after the last Fed meeting saying that he was very pleased with the US economy, citing solid growth and low unemployment. But he was less bullish about the rest of the world, saying that he saw a ‘bit of a slowdown in global growth’. His comments led to a modest slip in the percentage probabilities for future rate hikes for the first two quarters of 2019. However, investors still think that the probability of a 25-basis point rate rise next month is over 72%. The news has helped to underpin the dollar which is also getting a boost from Brexit woes, economic weakness across the Euro zone and uncertainty concerning Italy’s budget proposals. These were rejected by the European Commission last month. But the Italian coalition government is refusing to back down, saying that its deficit-busting plans for fiscal stimulus are the only way to end the country’s economic malaise. Perhaps they should consider leaving the euro.

Trump and the dollar

A rising dollar has a disinflationary effect for the US economy as imports cost less. This is a problem for the Federal Reserve as it struggles to maintain one part of its dual mandate, its 2% inflation target. But it’s even more of a problem for non-dollar countries. On top of this, President Trump has made no secret of his desire for a weaker dollar which he sees as necessary for US exporters to compete effectively in global trade. But can Mr Trump do much about the dollar given a gridlocked Congress? It seems unlikely that the Democrats would work with Republicans given their visceral loathing of Donald Trump. However, there’s one thing both Trump and Democrats love and that’s spending. So, we could see even bigger budget deficits down the line, adding to the national debt. But that takes us back to the Federal Reserve which has already made it clear they see a strong US economy which warrants tighter monetary policy. Add in another dose of fiscal stimulus and then you have even more reason for the Fed to continue to raise rates and reduce its balance sheet. Another thing to consider: Trump’s corporate tax cut was market-positive in that it directly fed through to companies’ bottom line. But infrastructure spending isn’t like that. Projects tend to favour specific companies while anything that’s done by government is likely to be mismanaged. So, we shouldn’t expect the stock market to get a lift from a infrastructure-intense spending splurge.

EURUSD chart

Here’s an updated version of the daily EURUSD. That broken neckline around 1.1450 now becomes resistance with some minor support around the 1.1300 area.

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