Well, the dollar gave a little bit back overnight, but not much.
Traders flagged profit taking when the baton was passed to London, but as you can see, the dip was fleeting:
All eyes will now of course turn to the Fed statement, which will be parsed for clues as to what the committee thinks about the inflation outlook now that we’re officially on target and in light of more evidence that wage pressures are building.
The dollar’s recent ascent (April was the best month for the greenback since the election) and its recoupling with 10Y yields and with rate differentials comes even as commodities have continued to climb on the back of geopolitical turmoil. That makes for an interesting juxtaposition.
On Tuesday, Goldman argued that rising commodities prices will mean looser financial conditions and last week, JPMorgan took up the petrodollar discussion again, on the way to suggesting that rising oil prices could prove to be a meaningful tailwind for equities as SWFs add to positions and companies buy back shares (just ask Norway about SWF equities accumulation – they’re all in, dammit).
There’s also an argument to be made here that the rising dollar will eventually cap the commodities rally and therefore put a lid on a rise in inflation expectations. We talked at length about that in “Are We Living In A Self-Regulating System?”
As noted above, this debate is playing out against an exceptionally fraught geopolitical backdrop and that’s in part what’s pushing crude higher. Specifically, the May 12 decision from Trump on the Iran deal looms large on the horizon and the idea of the “Bolton premium” is even more relevant now than ever. Netanyahu’s “Iran lied big time” presentation served to ratchet up the tension and was clearly designed to influence Trump’s decision.
Well in light of all that, Deutsche Bank is out with a new piece on the dollar, oil and the May 12 Iran date and it’s definitely worth a read. First, the bank tells you what will happen if sanctions are reimposed:
A US reimposition of sanctions, even if not supported by other P5+1 counterparties (China, France, Russia, UK, Germany) would most likely result in a reversion to pre-JCPOA conditions, whereby countries importing Iranian crude oil must show good-faith efforts to reduce imports by a significant amount in order to qualify for a sanctions waiver which allows them to continue importing reduced volumes. The reimposition of US sanctions would mean Iranian exports falling back to 1.4-1.6 mmb/d from 2.2 mmb/d currently, a decline of 600-800K b/d. However, the decline would take place over an extended period of 6 months to a year, as crude loadings to be delivered over the very near term have already been fixed. Variations in Iranian production and exports in response to previous sanctions shifts took place over similar time frames, see Figure 1.
Whether the Saudis would step in to fill the void is an open question and if U.S. production is constrained in its ability to ramp up, Deutsche sees “little standing in the way of crude oil prices approaching the $80/bbl mark.”
Ok, so what does this mean for the dollar? Well that’s where things get interesting.
With the data rolling over in Europe and with the U.S. economy continuing to hold up even as the economic expansion in America has officially become the second-longest in history, the “synchronous global growth” story is gradually becoming a story about the resilience of the American economy and the prospect that fiscal stimulus may ultimately be able to stretch the cycle further stateside, even if growth cools in other parts of the developed world. That appears to be buoying the greenback and contributing to a recoupling of the currency with rate differentials.
As Nomura’s Charlie McElligott wrote this week, “the ‘synchronized global growth’ narrative is now being capitulated against, and as such, the dollar has recoupled with rates differentials because the US is again viewed as the world’s leading growth-story.”
For Deutsche, this means that “the market is taking on board a view that the US will have a large fiscal inspired demand side shock that will more than offset any negative oil supply side shock, unlike much of the rest of the world, and the demand and supply side will provide a double whammy for US inflation pressures.”
In other words, rising oil prices would lead to rising inflation expectations and that would, in turn, make the Fed even more determined to hike as any hit to the U.S. consumer from higher oil would be outweighed by the effects of fiscal stimulus. Here’s Deutsche one more time:
In our FX blog on April 19 we noted that: i) regressions suggest a $5/b increase in oil is worth at least 10bps on US 10y breakevens; and, ii) if oil helps push the 10y yield into new terrain for this cycle, this will play at least mildly USD positive, in a change of correlation. If anything ii) significantly understated the shift in correlation and betas.
We would expect that oil heading to near $80/b will be associated with a stronger USD against most currencies. This partly relates to the impact at the back-end of the curve, most obviously if the US 10y yield breaks 3.05%. At least as important will be the expected Central Bank policy response. As we have seen in recent days, a few tentative signs of slowing in the global economy will scale back expectations of tightening in most places, while having less impact on the Federal Reserve.
Clearly there’s a self-feeding loop built into that equation and it raises questions about what happens to financial conditions if the dollar continues to climb, and long end yields continue to climb (and if the correlation continues to get stronger, that dynamic could start to optimize around itself) while crude prices begin to squeeze consumers. It sounds like a rather precarious setup that has the potential to easily outweigh whatever presumed loosening of international financial conditions might come along with a continued rise in commodities prices.
Food for thought.