Forget Trade Talk: The Fed Is Still Driving The Direction Of The Dollar

Over the last year or so I've changed my thoughts on the dollar a few times.

I've thought that it has to collapse as the Fed unwinds... but then realized that as the Fed unwinds, it's likely to create a dollar funding problem first, which should push it up.

I think we've seen the first cracks of this.

I wrote this article back in 2016 in relation to oil, but there was a particular section that I wrote that is very relevant to the first 2 quarters of 2018.

I think I've only got once component of this prediction right so far, but the drop off in oil yesterday could be correlated to the shorter term USD strength, which may be sustained down to the $65pb level.

I do think oil is overpriced with current conditions and has been following Hotelling's Rule of price being correlated with Fed interest rate path, but that's neither here nor there.

The main question is where is this dollar going?

Here's a chart of my midterm view.

Simple stuff - coming off the yearly highs, looking at broken range resistance to use as support, then a push to the upside.

I do feel the dollar needs to come off a little just to have a rest, which would imply a push up on Euro to 1.20ish... and then a tough collapse to sub 1.10.

Dollar money market fundamentals support this view, firstly by showing how much the Fed have been dumping relative to the latter part of 2017:

But secondly, that now the Fed balance sheet differential and the ECB balance sheet differential is widening rapidly:

This gives us a picture coming from two angles.

The first being that USD has some catching up to do with USD LIBOR as the Fed unwinds further, decreasing dollar liquidity through increasing the demand for USD. I think our initial drop in USD will come as the Fed slows this over the rest of summer and will pick up the pace again in October/November, where we'll see the dollar index break 100 again.

Secondly, we have the other part where the Eurozone is more likely than not going to face some more issues, especially as the Eurodollar market faces the same issues with liquidity through further Fed unwinding.

The above problem can be seen with the Turkish Lira.

Turkey is one of the most heavily externally indebted emerging market economies in USD.

Fed unwinding pushes yields up which causes that debt to become more expensive to service. Since Turkey had borrowed so much in USD terms to service its economy, its interest payments are starting to spiral, causing a huge depreciation in TRY.

This is the best current evidence of what will occur... and the Fed have hardly done anything yet...

As you may know, I believe that this is the true story. All trade war talk is pure noise and is affecting little long term in terms of currency direction.

I like to think in thematic priority - what is the big story that is driving direction, but what is the story that will drive the market to intra-month support or resistance?

For me the trade war is doing the latter - so we must remember, just never fight the Fed. I think some are forgetting that.