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Abu Dhabi, UAESunday 23 September 2018

While the US dollar shone in May, it is now taking a breather

Gaurav Kashyap says the current pullback over the last few days is only natural

Dollar-denominated instruments are attracting heavy interest, leading to a show of strength in the currency markets. Photo: EPA
Dollar-denominated instruments are attracting heavy interest, leading to a show of strength in the currency markets. Photo: EPA

Many new themes developed in May in the financial markets, which drove volatility in certain asset classes while others found themselves lagging and instead trading sideways.

The US dollar continued to shine last month, with the Dollar Index ramping up by 2.55 per cent to trade at its highest levels since November. Back then the Greenback faced stiff resistance at the 95 handle, which was my upside target for the month as published back on May 9.

Similar to the price action from six months ago, the dollar ran out of steam just below 95 levels where it is currently consolidating. Continue to watch how the index trades around this level – the pullback from the last few days is only natural in what seems a phase where dollar longs take a breather. While many foresee a breakdown from the current levels; my outlook for the dollar remains strong for the initial weeks of June, after which forecasts for the currency could get tricky.

As expected, the Fed maintained rates at 1.75 per cent at their last meeting in May, and also as expected, they will resume their rate hiking cycle when they next convene to announce rates on June 13. While it is a near certainty they will increase from 1.75 per cent to 2 per cent this month, it is the upcoming economic projections that will give clues on whether we can expect to see if not one, but possibly two more hikes in 2018.

We have often noted the improving fundamentals out of the US with the most recent US Non-farm payrolls report from May solidifying this view. Payrolls grew 223,000 last month, snapping a run of two subpar months and dragging the average monthly jobs gains in 2018 above 200,000.

The unemployment rate dropped to 3.8 per cent - an 18-year low – and perhaps most encouraging, wage growth continued to expand month on month at 0.3 per cent versus 0.1 per cent previously.

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Despite the improving figures across the board, the proof in the pudding remains inflation data. With year-on-year core prices dropping in May to 2.1 per cent instead of the expected 2.2 per cent, this took a bit of heat off the Fed (and dollar hawks) and the upcoming June reading – due out on June 12 will no doubt see volatility spike in the lead up to the rate decision which falls a day later.

A beat of the previous yearly reading above 2.1 per cent would spark a fresh dollar rally heading into the Federal Open Market Committee, while a miss would tamper such expectations. It would prove prudent to avoid any dollar strategies until we get that inflation print.

Keep an eye out for the yield on the US 10-year treasury - another developing theme we have been tracking. After crushing through the 3 per cent handle, there was some significant downside pressure which saw yields drop to the current 2.8 per cent levels. Watch for an upside move in the 10-year yield to keep gains in the S&P capped at 2800 levels with a move below 2675 expected in the weeks ahead.

The other key theme from May has been the performance of crude oil. After spiking above 72.80 levels, the Dubai Gold & Commodities Exchange (DGCX) contract sunk 2.2 per cent last month, and in the three days of June has already shed another 3 per cent. The sharp sell off came after Russia and Saudi Arabia signalled their intent to raise oil production.

The news came as a surprise to energy markets as just a few months prior, both nations publicly welcomed higher oil prices. The timing of such an announcement - a month before Opec converges in Vienna on June 22, not to mention coming a month after President Trump tweeted complaining about higher oil prices - would suggest that there may be something larger at play.

Weekly crude data from the US last week showed that despite the large buildup in weekly inventories, both US production and exports were up again last week. While this may be a result of the Brent/WTI spread widening as high as $11 (US Crude exports would increase due to the large discount), option market positioning suggests a further leg lower in crude prices through the middle of June. Fundamentally, expected curbed Iranian exports and Venezuelan outputs at near lows (PDVSA, the state run oil firm, operated at 31 per cent in the first quarter, with the future of their Curacao refinery in doubt) will keep pressure on crude prices. Expect weakness in the near month contract to drag WTI prices into the channel between 60-62, a clean break of which would expose 58 levels.

Finally, the euro achieved and crushed through my lower target of 1.18 last month, with the DGCX EUR/USD contract tanking below 1.16 levels. While I expect the current relief rally to keep the euro treading above 1.16 through this week, watch for volatility to pick up in the week of June 11 with a hat trick of key releases set to further drive the euro trend. While the previously mentioned inflation and FOMC rate decisions will drive dollar pricing, this will be capped off by the European Central Bank rate decision, which falls a day later on June 14.

Gaurav Kashyap is a market strategist at Equiti Global Markets

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