A common question asked by our readership is whether the rally we’ve seen in the dollar since early 2016 is beginning to run out of steam, or if the ‘divergence trade’, which has been driving the USD higher since 2014, is going to continue to remain in play through 2017. Our view for the dollar remains, on balance, bullish – however we would warn that risks to that view are beginning to inch higher.
Whilst a Trump victory has certainly reignited optimism in the US economy, fundamentals do not appear to be keeping up with this change in sentiment. In fact, historical divergence between these two factors are now at all time highs.
One way to measure how business and consumer optimism (‘soft’ data) stack up against fundamental indicators (‘hard’ data), is to look at the spread between market indexes which measure the two. One such measure is the data surprise index – the degree to which actual economic releases over or undershoot analyst expectations. For example, a consumer confidence survey which beats expectations is said to be a positive data surprise, which usually sends markets higher, whereas an undershoot on a fundamental trailing indicator would generally send markets lower.
Splitting this data surprise index into its ‘soft’ and ‘hard’ component parts can provide us with valuable insight as to whether market participants (i.e.: those responding to market surveys) are overly optimistic relative to what is actually being observed in the economy (as measured by fundamental indicators).
Looking at the below we see that market optimism (as represented by ‘soft’ data in orange) is clearly outpacing market fundamentals (shown by ‘hard’ data in blue). In fact, the divergence between these two are at the highest levels observed since the indexes were first constructed in 2000.
Chart 1: Soft Data Surprise Index (orange) vs Hard Data Surprise Index (blue)
What does this mean for the divergence trade? In our opinion, there are two risks which need to be considered when evaluating whether relative dollar strength will persist:
- The risk that Trump’s policy plans are fundamentally flawed (that is, that they will simply fail to deliver promised economic growth), and;
- The risk that even if policy plans are feasible, that Trump will be unable to win enough support to implement them successfully.
The first point we could debate for days – however it is reasonable to assume that a programme of tax cuts and infrastructure spending will be expansionary in the short term, thereby supporting a continued monetary policy divergence between the US and much of the rest of the G10, and a broadly stronger USD. However, the second risk is, in our view, one which is becoming increasingly dangerous to the ‘long USD’ trade. Put simply, Trump may not get anything through the House or Senate.
Just a few months in and one of Trump’s biggest campaign promises – to repeal and replace Obamacare – has hit a major stumbling block, with the bill being pulled after failing to receive enough support from House Republicans.
Now the fate of Trump’s promised tax reform is now being drawn into question, as the much-needed financial headroom to fund such a cut will no longer be made available by his plan to repeal and replace. Is this failure the first of many? Some reports suggest this will delay tax reform to at least early 2018, and the promised infrastructure bill even further.
Chart 2: US Dollar Index
Whilst we recognise that the dollar has seen a ~4% pull-back since the start of the year, we continue to maintain our bullish view (against most G10 currencies with the notable exception of GBP). We know that positive sentiment has been a driving force which has sustained the Trump trade over recent months – optimists have kept equity and dollar markets well bid. That said, we must caution that we see elevated risks to our view in the medium term, particularly should Trump’s first quarter in office be any indicator of what struggles are to come. Most notably, that his government is unable to live up to relatively unprecedented market optimism.
Author: Josh Macdonald