Dollar extends rally but its days as King of FX could be numbered

Unless the US dollar falls sharply from now on until the end of the year, the Dollar Index will end 2018 on the back of three consecutive quarterly gains. But to assume it will finish 2018 this way would be very risky in my view. I actually think that the days of the dollar’s reign as King of FX could be numbered. However, at this stage, I am merely on the lookout for bearish price patterns to potentially emerge on the currency, as we haven’t seen any reversal signals thus far. Obviously, a strong US economy and the accompanying rate hikes from the Federal Reserve have undoubtedly helped to push the dollar higher, not to mention the impact of raised import tariffs on goods arriving from China pushing up inflationary pressures. Meanwhile safe-haven flows out of emerging markets and into the US dollar has further supported the rally. Elsewhere, ongoing political and economic uncertainties in Europe have kept the pressure on the EUR/USD and GBP/USD, while the sell-off in crude oil prices has seen the Canadian dollar losing its appeal in favour of its southern neighbour and so the USD/CAD has rallied. But these developments have already happened and therefore at least partially priced in. Is it time therefore for the dollar to now start heading lower? The Federal Reserve could very well change its hawkish outlook in the upcoming meeting, although so far we have seen some mixed commentary from Fed officials. Clarida was surprisingly hawkish today after a couple of other members last week had tried to soften the Fed’s hawkish tone. Meanwhile, a potential trade deal with China could also be dollar-negative.

Trump secretly desperate to strike trade deal with China

In an interview with the Wall Street Journal yesterday, Mr Trump has again used his aggressive tough-talk tactics ahead of his meeting with Xi Jinping at the G20. The US President threatened to impose tariffs on $267 billion of Chinese imports “if we don’t make a deal,” he said. Mr Trump’s unorthodox negotiation tactics have been rather controversial to say the least. But proponents would argue that he has managed to successfully renegotiate trade deals with its neighbours Mexico and Canada, while he has also made some North Korean friends. The fact that he’s applying the same approach to China isn’t a surprise. But after boasting so much about the stock market gains, he will be desperate to forge a deal now that the major US indices have turned red on the year. So, if a trade deal were to be reached, our assumption is that import duties will be lowered again which should push down import costs and therefore be disinflationary. That in turn should further reduce the urgency from the Fed to hike rates, and potentially lead to a rally in stocks and a drop in yields and the dollar.

Fed bigger problem than China: Trump

Regardless of the outcome of the US-China trade deal, the US dollar and bond yields may start easing back anyway. The recent turmoil in emerging market currencies has undeniably hurt demand. This has been highlighted, for example, by falling sales of the iPhone and a drop in German exports causing their economy to shrink in Q3. Other economic pointers in Europe have been far from impressive, raising doubts that the European Central Bank would be in a rush to raise interest rates next summer – especially in light of the recent plunge in oil prices. In the US, too, we’ve seen some softer-than-expected macro pointers lately, triggering a couple of Federal Reserve officials to talk cautiously about the prospects of further economic expansion. At the same time, the Fed’s hiking cycle has been heavily criticised by Donald Trump himself. Indeed, the US President has gone as far as to say that the “the Fed right now is a much bigger problem than China.”

Fed Vice Chairman: Gradual Rate Hikes Needed

The Federal Reserve’s Vice Chair actually ignored Trump’s warning today and maintained a hawkish rhetoric, leading to further gains for the dollar. Richard Clarida backed "gradual rate hikes," before adding that “moving too slowly could result in rising inflation and inflation expectations down the road that could be costly to reverse, as well as potentially pose financial stability risks."

In a nutshell

Taking everything into account, the Fed is still one of the most hawkish central banks out there and this is reflected in the dollar rallying. But with the pressure growing from Trump and given the recent fundamental developments, the central bank may well change its tone soon, potentially leading to a dollar sell-off.

Source: TradingView and FOREX.com.