The Dollar Is Overdue For A Drop
The U.S. dollar is headed lower…
This week is an important one for investors from an interest rate outlook perspective. Not only do we receive an update on personal consumption expenditures, as I discussed yesterday, but the Federal Reserve and European Central Bank are both slated to make monetary policy announcements. The outcomes will be closely watched to see how they affect rate-sensitive assets like stocks and bonds.
Now, if you mention the word "currency" to most retail investors, they probably think about the dollar and stop. What they fail to realize is that the dollar index is made up of six other currencies… the euro (EUR), the Japanese yen (JPY), the British pound (GBP), the Canadian dollar (CAD), the Swedish Krona (SEK), and Swiss franc (CHF). So, when those currencies move higher and lower, they drive the dollar in the opposite direction.
The breakdown is as follows…
As you’ll notice, the most important component of the index is the euro. It makes up 57% of the Intercontinental Exchange’s dollar index. So, if the euro rallies, there’s a good chance the dollar’s about to drop.
Right now, expectations for Fed rate cuts in 2025 are low. Conversely, expectations for ECB borrowing cost reductions are high. If either scenario plays out in the opposite direction of what bond market speculators predict, it will cause the dollar to drop and the euro to rise, fueling a rally in the S&P 500 Index.
But don’t take my word for it, let’s look at what the data’s telling us…
The Fed is set to update monetary policy on Wednesday. Wall Street expects our central bank to leave the federal funds target rate unchanged in a range of 4.25% to 4.50%. However, it’s the outlook for additional rate cuts this year that matters the most.
In September of last year, policymakers guided for 100 basis points worth of rate cuts in 2025. That meant the federal funds target range would drop to 3.25% to 3.50%, or 200 basis points below the 2023 peak of 5.25% to 5.50%.
However, that changed in December. Fed officials expressed concern about the path of inflation growth going forward. Some members worried the potential tariff policies of President Donald Trump could drive up costs. Consequently, they reduced the outlook for 2025 rate cuts from four to two and raised the outlook for inflation growth this year from 2.1% to 2.5%.
The shift caused Wall Street to grow even more pessimistic, reducing its expectation for rate reductions from four to one. The dollar shot up as a result…
But now, that’s starting to change. So far, the Trump administration hasn’t been as aggressive out of the gates with tariffs as the president had promised on the campaign trail. Now, don’t get me wrong, he’s still discussing the use of them, but the levels of implementation appear to be less than his initial claims. In addition, Trump has expressed a willingness to negotiate with other nations to avoid the use of levies.
But what about the euro?
The European Central Bank is set to update monetary policy on Thursday. Wall Street expects it will lower the benchmark deposit facility rate by 25 basis points from 3% to 2.75%. In addition, it expects European borrowing costs to fall by another 75 basis points to 2% by year end.
That’s a much different outlook than our central bank, causing the euro to drop…
A primary driver of this shift is slowing growth in Europe. Germany, the region’s largest economy, saw economic output contract by 0.2% last year. That marked the second straight year that activity declined.
The development caused policymakers to change their tone. Traditional hawks (inclined to raise rates) like Chief Economist Philip Lane and Bank of Finland chief Olli Rehn have said rates too high for too long are killing growth. So, they want to ease borrowing costs in an attempt to spark a rebound in consumption.
If we look at the above charts of the dollar and the euro, we notice something interesting… the dollar hasn’t been this strong relative to the euro since late 2022. At the time, investors were worried about rising rapidly rising borrowing costs choking off growth. At the same time, Wall Street worried the European economy was collapsing. Yet, within a few short months, those concerns were placated as the Fed and ECB dialed back the pace of rate increases and eventually stopped. Over the next year, the S&P 500 rallied 15%.
Now, here we are today. Once again Wall Street’s worried about the path of U.S. Treasury yields. They’re worked up about an inflation rebound and discussing the potential for Fed rate hikes. And just like last time they’re worried that Europe is on the verge of falling apart.
So, don’t be surprised if these worries prove to be overblown…
The outlook for Fed rate cuts is starting to change. Wall Street is pricing a second rate cut this year as inflation worries ease. If the White House’s bark proves to be worse than its bite, those same price pressure concerns could drop even more. That would boost the outlook for more 2025 rate cuts, causing the greenback to fall.
In addition, the ECB is looking to boost growth. At some point, rate cuts will encourage households and businesses to borrow more. That will drive spending and demand. Such a development could cause bond market speculators to rethink the outlook for ECB rate cuts, causing the euro to rise. And while the shift may not support the type of rally we experienced last time, ti should underpin a steady rally in the S&P 500.
Five Stories Moving the Market:
Nvidia said Chinese AI firm DeepSeek's advances show the usefulness of its chips for the Chinese market and that more of its chips will be needed in the future to meet demand for DeepSeek's services - Reuters. (Why you should care – Nvidia said DeepSeek shows how leveraging the use of widely available models, using its chips, can create newer versions, likely boosting demand)
Due to the Federal Reserve’s annual board rotation, new voters could shake up central-bank meetings this year; the new voters on the rate-setting Federal Open Market Committee in 2025 are one official who is seen as one of the system’s most dovish, as well as a centrist and two new faces who could bring a more stringent anti-inflation perspective – WSJ. (Why you should care – based on the new make-up, policy debates could shift in a slightly more centrist direction)
Sales of new U.S. single-family homes increased more than expected in December, further evidence that housing market activity regained some momentum at the end of 2024, though rising mortgage rates remain a constraint – Reuters. (Why you should care – the pace of price growth continues to slow, likely placing downward pressure on inflation)
Stocks haven’t looked this unattractive, by at least one measure, since the aftermath of the dot-com era; the equity risk premium, often defined as the gap between the S&P 500’s earnings yield and that of 10-year Treasurys, turned negative in late December for the first time since 2002 and sat last week at negative 0.15 percentage points – WSJ. (Why you should care – investor skepticism about equity returns could increase if U.S. Treasury bond yields remain elevated)
China’s economic activity unexpectedly faltered to start the year, as Factory activity shrank in January after three months of expansion, breaking the momentum of a recovery sparked by stimulus measures and underlining the need for Beijing to do more to prevent another slowdown – Bloomberg. (Why you should care – China’s economy continues to suffer from the continued loss of manufacturing due to intellectual-property theft concerns)
Economic Calendar:
Earnings – BA, GM, IVZ, LMT, SBUX, SYF
Markets Closed in China, South Korea, and Taiwan
ECB Bank Lending Survey (4 a.m.)
U.S. – Durable Goods Orders (Preliminary) for December (8:30 a.m.)
U.S. – FHFA House Price Index for November (9 a.m.)
U.S. – S&P Global CoreLogic Case-Schiller Home Price Index for November (9 a.m.)
U.S. – Conference Board Consumer Confidence for January (10 a.m.)
U.S. – Richmond Fed Manufacturing Index for January (10 a.m.)
U.S. – Dallas Fed Services Index for January (10:30 a.m.)
Treasury Auctions $85 Billion in 6-Week Bills (11:30 a.m.)
Treasury Auctions $30 Billion in 2-Year Floating Rate Notes (11:30 a.m.)
Treasury Auctions $44 Billion in 7-Year Notes (1 p.m.)
U.S. - American Petroleum Institute Crude Oil Inventory Data (4:30 p.m.)