Five Reasons Dollar Is Going On A Roller Coaster

USD may not extend its downtrend since early 2017. Sell EUR/USD?

The Fed could act more hawkish as what investors are expecting now

In our “Weekly Market Report” last week, we mentioned “Why Dollar Bull Is Likely to Run Out of Stream” even as Trump proposed the tax reform plan in detail. The Dollar’s trading pattern was in a range last week. We do not see a substantial dollar rebound in the final quarter of the year. However, in this report, we will explain why you should not sell US dollar consistently, even after poor payroll numbers reported last Friday.

The Dollar index had been falling in the last three consecutive quarters. Wall Street has a good saying: “Trend is your best friend”. We think applying this rule on the dollar in this quarter carries tremendous risk, and here are five reasons why.

Reason #1: Don’t focus too much on NFP, watch the unemployment rate as well

Nonfarm payroll employment decreased 33,000 in September, the first contraction in seven years. Data showed sharp employment decline in food & beverages services and below-trend growth in some other industries. This reflected the impact of Hurricanes Irma and Harvey. Such outcome showed weak NFP don’t reflect the economic fundamentals and the Fed has no reason to set policy outlook based on the payroll numbers this month.

The unemployment rate in September declined to 4.2%, lowest level since 2001. It is worth taking a look. With the unemployment rate heading towards 4% and probably falling below, the Fed must respond to “very tight” US labour market by gradually raising interest rates or risk halting the economic recovery. Prudent risk management would argue for continued gradual removal of monetary policy accommodation, in order to minimise the risk of shortening the current economic recovery prematurely.

Thus, market will start to gauge and price in the number of Fed hikes in 2018 in the coming months. This is likely to be dollar positive.

Reason #2: Weak dollar has benefitted the labour condition in US manufacturing sectors, better corporate profits mean a better US economy

Ignoring the latest payroll report, US manufacturing payroll had been improving in the past 12 months, thanks to the weak dollar. Soft dollar lifted the manufacturing companies’ profit, suggested a more solid US economy. Improving profitability in US companies echoed the current uptrend in its stock market, which should be positive to US dollar.

Reason #3: The Fed could be more hawkish than you are expecting, Yellen’s behaviour could be a “good message”

Yellen’s term as the Fed president could end by next February. In recent weeks, Yellen kept emphasising the importance of containing financial risks, suggesting the rate hikes will continue despite the below-target inflation data. As we know, rising interest rates would obstruct Trump’s economic plan in two crucial ways: higher interest to pay and collapse of the stock market.

Do not let this mislead you. This is about economics, not politics. Our best guess is Trump’s economic reform agenda may gradually kick off in 2018, including the recent proposal of tax reform. If so, the Fed will do its best to contain the financial risk, otherwise bubbles will be created in the various US financial sectors.

Reason #4: “ECB play” positions are exhausting

Let’s face one reality; USD weakness in earlier months was mainly driven by euro strength. Now there are less investors believing ECB is in a rush to tighten their monetary policy. Many of the traders started to close earlier “long euro” positions. After EUR/USD broke above 1.20 last month, the pair fell back quickly below 1.20. Such price reaction suggested there were not much interest in the market to purchase EUR/USD when it is above 1.20, before Mario Draghi makes clear the timeline of its QE tapering.

Reason #5：US Treasuries’ largest foreign holders may continue buying towards year-end

After Chinese yuan has stabilised this year, nation’s capital outflow pressure is mitigated. Two reasons may drive Chinese central bank to buy US Treasuries, which is equal to buy the dollar in near term. First, PBOC looks keen to defend its FX reserves at USD 3 trillion level. Second, PBOC may not be comfortable with its currency rising too quickly.

Our Picks

EUR/USD – Slightly bearish.

This pair may fall towards 1.1680. US CPI may offer support to the dollar this week.