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The dollar’s correction is probably over

The US dollar had been in free-fall since the year began (-7.3% in effective terms between early January and late August), but it is rebounding and is now having its best month in 2017. 

Why has the USD depreciated so much this year?

After a period of post-election euphoria and with inflation accelerating (largely due to oil-related base effects) between November and January, the markets had begun pricing in a much quicker cycle of fed funds tightening. However, the unexpected slowdown of inflation (headline but also core) between January and June lowered expectations that the Fed would tighten its monetary policy.

At the same time, hopes for an acceleration of growth have been dashed by the new Trump administration, which has also weighed down US long-term rates and the dollar. Congress and the US President have failed to see eye-to-eye on several major issues, and the US GDP growth forecasts have remained extremely stable. On this point, there has been a notable divergence with the rest of the world, because growth forecasts have been revised upward in many countries or regions, such as the eurozone, Japan, and China.This divergent trend in growth forecasts have weighed on the dollar.

Why is the dollar rebounding?

First, several signals on inflation have become more reassuring:

  • headline inflation rose slightly in July and August.
  • core inflation has stabilized in recent months (in the month of August, core inflation (core CPI) stood at 1.7% for the fourth consecutive month)
  • other indicators like the "Underlying Inflation Gauge" calculated by the New York Fed are a reason to be relatively optimistic on inflation and projected inflation in the US.

It is clear that the inflation trend has been a problem for the Fed in 2017. Moreover, Janet Yellen said at the latest FOMC that inflation's deceleration this year has "something of a mystery." However, FOMC members have appeared a bit more optimistic on the subject recently. As it happens, this week Yellen gave a speech to that effect ("Inflation, Uncertainty, and Monetary Policy"): "[S]tandard empirical analyses support the FOMC's outlook that, with gradual adjustments in monetary policy, inflation will stabilise at around the FOMC's 2 percent objective over the next few years"  What's new in Yellen's message is that, with conditions having improved so much on the labour market, the uncertainty requires a fed funds adjustment that is not too rapid (as it may dampen inflation's rise), but that is not too slow either (as it may cause the labour market to overheat).Consequently, the markets are now readjusting their anticipated fed funds path upward, which is pushing US rates higher. We believe that the markets are still too pessimistic about the evolution of the fed funds in the coming quarters.

The fact that tax reform is becoming a priority for the Trump administration - after failures on several other bills - is another factor supporting US growth and the dollar. However, it remains to be seen how the President will manage to win over a majority in Congress, and which changes will have to be made to the president's reform bill before it can be adopted. 

While it is unlikely that the dollar will rebound strongly in the coming months, it is highly likely that the dollar's correction is over.

 

2017.09-expert-talk-graphe

 

DRUT Bastien , Fixed Income and FX Strategy
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The dollar’s correction is probably over
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