- Correlation between US dollar and equities is turning strongly positive again…
- …suggesting currency is well positioned for a cyclical lift
- Eurozone core inflation at record low, making the case for ECB action
US dollar’s correlation with the Dow and interest rates suggests its cyclically driven
At the beginning of 2013, the US dollar was cyclically-driven. It strengthened on any signs of better prospects for the US economy and moved in tandem with US equities. The strong positive correlation (see yellow line in chart) at the start of 2013 reflected this dynamic. In short, both US stocks and the US dollar moved higher because of optimism about the US economy. When the possibility of Fed tapering came to the fore, dynamics in FX markets changed. Expectations about tapering and subsequent rate increases, became more dominant drivers and the correlation between the Dow Jones and the US dollar fell as investor sentiment also deteriorated. Recently, the US dollar and the Dow Jones have started to move in tandem again. What explains this? Once again, the market has become more positive about the US economy and investor sentiment has improved as well. For this year, we expect interest rates expectations and the state of the US economy to be dominant positive drivers for the US dollar and we hold an above consensus view about 2015 rate hikes and an above consensus view on US GDP growth. In short, we think the US dollar looks all set for a cyclical lift.
Long-term dollar fundamentals also improving
Apart from the cycle, structural fundamentals are also very clearly turning for the better. Monthly data suggest that both the budget as well as the trade deficits are shrinking significantly. The latest sign of these improving balances came in yesterday’s trade deficit data for November. It fell to USD 34.3bn from USD 39.3 bn in October. This was the smallest deficit since October 2009. The decline in the deficit was largely driven by sharp improvement in the petroleum deficit, which is a reflection of the shale energy revolution. The improvement of the deficit taken together with other monthly economic data points to a well-above trend reading for US GDP growth in Q4. This would be the second successive quarter of very strong rates of expansion signalling that the economy has taken off.
Eurozone core inflation at record low
The flash HICP estimate for the eurozone reported a fall to 0.8% in December from 0.9% in November, in line with expectations. The decline was driven by a larger drop in the core inflation rate to 0.7% from 0.9%, which took it to the joint lowest level on record. The fall in core inflation was driven by falls in service sector inflation (down to just 1% – another record low – from 1.4%). The latter could for a part reflect a sharp drop in the price of German package holidays, which are volatile. However, there are broader more fundamental disinflationary forces at play in the service sector and elsewhere. The high levels of unemployment are leading to declining wage growth, which in turn is bearing down on service sector prices. Headline inflation would have dropped by more were it not for upward effects from food and energy price inflation. Given that global food price indices have plummeted, the rise in food price inflation looks set to be a blip in an otherwise downward trend. Furthermore, base effects related to oil prices are likely to again pull annual energy inflation into negative territory again in coming months. Finally, core goods prices will also come under further downward pressure as import prices decline because of the strength of the euro and weak global manufactured goods price inflation. The bottom line is that headline inflation is not only very low, but will likely fall further in coming months. The very low inflation trend means that further ECB action remains on the table, though probably not already this week.