Thursday , January 24 2019

Global rally in stocks may depend on dollar

Stock markets started the year on a strong note, and everyone seems to be asking the same question: How much more can high-risk assets appreciate? The dollar may provide the answer. The US currency’s weakness throughout 2017 provided much support for the domestic economy, arguably more than even the anticipation of tax cuts that boosted equities. It has also been great for the global economy, especially emerging markets, which have borrowed heavily in dollars in recent years. The dollar’s depreciation also reflects a stronger euro and pound that
resulted from strength in the European and UK economies.
There are costs associated with a falling dollar. In general, it means higher prices of commodities, which are settled in the US currency. The rising cost of energy and materials has added to top-line inflation, bolstering the confidence of central bankers that their inflation targets will be reached soon. As such, traders have pushed short-term nominal interest rates higher. These, in turn, have begun to push real interest rates higher. A change in the landscape for real interest rates may help strengthen the dollar and, ultimately, damp the current Goldilocks-like feeling sweeping global markets.
Take, for example, the surge in demand for dollars at the end of 2017. Although it is a seasonal phenomenon, it is driven by currency repatriation, leaving fewer dollars in the funding markets. Recent positioning data published by the US Commodity Futures Trading Commission shows short positions in the dollar have largely been reversed. That means 2018 starts with a clean slate in dollar positioning that creates the potential for a buildup in long positions when US economic data gathers strength.
Tax reform may also fuel the dollar’s appreciation as the impact of the cuts is felt through the economy. Then there are the tensions on the Korean Peninsula and US President Donald Trump’s seeming desire to start an arms race, which could underpin the value of the dollar. There’s also the chance that the Federal Reserve might shift the emphasis of its focus from the labor market to gross domestic product and inflation. Minutes from the Fed’s last monetary policy meeting signaled concern that faster inflation could require a faster pace of rate increases. Some policy makers were also concerned the lower zero bound may come in sight again, and those members argued for a new policy framework that includes GDP or price level targeting.
All these reasons serve to underscore the dollar smile theory, which says the greenback should appreciate on a stronger economic outlook. In real effective terms, the greenback has already begun to show some strength amid evidence that inflation is starting to slowly accelerate. In the past when the dollar declined in nominal terms but rose in real terms, the US currency experienced a significant appreciation. And that means a resurgence in the dollar can tighten financial conditions and reverse some of the good spirits currently embedded in global markets.

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