For almost seven months, the value of the U.S. dollar has declined versus most major foreign currencies.
DXY Index of the USD versus Major Foreign Currencies YoY (Bloomberg):
When a currency falls in value, it is inherently inflationary. Thus, if the dollar continues to weaken, we could see CPI and PCE stabilize and, possibly edge higher. Will it cause Core PCE rise to or above the Fed’s 2.0% inflation target? Possibly, but I think the increase will be more moderate. Still, even a moderate boost to U.S. inflation could put a floor under long-term UST yields and could push them moderately higher. Hence my range for the 10-year UST yield is, roughly 2.20% to 2.50% (possibly 2.60%). We must understand that in the world of foreign currency exchange, when one currency goes down in value, there must be a currency or currencies which increase in value. Thus, if a declining USD is potentially inflationary than a rising EUR is potentially disinflationary or deflationary.
As you can see, as the EUR fell against the USD, late in 2016, EMU CPI climbed. However, as the euro rallied versus the U.S. dollar, EMU CPI plateaued and has begun to slide. This causes a problem for the ECB and its plans to renormalize monetary policy. It has been the rebound of inflation which has emboldened ECB president, Draghi, to sound less dovish, but if the EUR continues to strengthen or even remains at or near current levels, he may have to put off renormalization plans. Renormalization is likely to maintain a
strong euro currency, which would likely reduce inflation pressures and hamper exports. As exports are much relied-upon for EMU GDP (particularly for Germany), a strong/stronger EUR could spell an end to the economic rebound in Europe. Noted trader, CNBC “Fast Money” panel member and Bond Squad friend, Guy Adami, expressed similar sentiments last evening on “Fast Money.” I will be on a conference call with Guy, tomorrow afternoon. I will discuss the conference call in this weekend’s “In the Trenches” report.
Other than by delaying renormalization plans, central banks can also attempt to combat rising currency values by purchasing U.S. Treasuries, which requires converting home currencies to U.S. dollars (something which I have discussed on multiple occasions). If central banks were doing this, we should see this show up in the TIC Flows data, particularly Long-Term TIC Flows. We got that data last night.
Long-term TIC Flows data indicate that foreign investors increased their purchases of long-dated U.S. debt from $9.7B (revised from $1.8B) to $91.9B! This is not a typo. This is data from May. With the USD trending lower, again, I expect that we will see strong foreign purchases of long-dated U.S. bonds in the June and July data, as well. This is behind my belief that the USD may be close to its near-term bottom. I also believe that foreign buying of long-dated Treasuries was behind the drop in long-term UST yields, before the last Fed meeting, and the decline of long-term UST yields, during the past two weeks.
I expect the long end of the curve to be well supported by foreign investors, but we could see some upward yield movement in long-term rates (albeit temporarily) from somewhat hotter inflation pressures due to both year-over-year oil price comps and a weaker dollar. However, by the fourth quarter, the upward move in inflation should dissipate, causing long-term yields to stabilize, if not fall. It is from this outlook that I derive my range-bound outlook for the long end of the UST curve.
Oil bulls have been mooing about the recent rise in oil prices. They point to a larger than expected drawdown of inventories as a fundamental reason for higher oil prices. They conveniently leave out that U.S. oil production has begun rising in response to the increase in consumption, which is normal at this time of the year.
I believe the main reason for the recent surge in oil prices is the weakening of the U.S. dollar. Oil is priced in USD. Thus, if the USD loses purchasing power, it takes more dollars to purchase a barrel of oil. As such, an increase in oil prices is not surprising. However, when we consider how far the USD has declined, in the currency markets and that the price of WTI is only about $47 a barrel, it appears that underlying conditions augur for lower oil prices for longer. I heard whispers from oil market participants who suggested that, almost the entire rise of WTI from $44 to $47 was due to the latest round of USD weakening.