USD Soft Patch to Set the Stage for Another Grind Higher in Asset Prices and Interest Rates

  • Bullish USD sentiment clearly became overly reliant on the Trump Administration’s desired agenda of tax cuts, deregulation, and infrastructure.
  • Due to the host of potential political scandals plaguing the Administration, as well as general political dysfunction in the US Congress, expectations of a pro-growth agenda being enacted this year have been significantly muted, though not completely discounted by Assist FX.
  • Assist FX still sees passage of a lighter version of market-friendly reforms in 4Q2017/1Q2018 limping past the finish line in what is becoming a non-consensus call. Sparring blocs within the Republican party will increase cooperation as political viability becomes increasingly threatened for the 2018 midterm elections.
  • In the near term, USD will struggle to stage sustainable rallies as political uncertainty takes its toll.
  • As financial asset prices in equities, real estate, and alternatives continue to inflate further into historically stretched valuation territory, it will place pressure on the Fed to remain on track for gradual rate hikes approximately once per quarter.
  • Long duration USTs will be pressured by lower real yields, lifting rates at the long end of the curve. This will contribute to moderate firming in USD in the medium term 3-6 month outlook.
  • Top risks to this view include a pronounced spillover effect from China’s debt deleveraging efforts resulting in global financial market instability, as well as any number of potential Trump Administration scandals escalating to such severity that the blow-back shifts the political landscape in favor of left leaning populists for 2018 and beyond. While these risks are currently underappreciated by markets, they are not our base case.

Change in Oil Market Outlook to Relieve Pressure on Fed Rate Hike Pace

Energy trader positioning has been heavily long oil and that trade seems to be unwinding. I am guilty of not weighing enough importance on market positioning in initiating a $60 WTI price target back in December. While initially thrusting higher per expectations on satisfactory OPEC compliance during the first two months of 2017, there were not enough new buyers in the market to push WTI to the full $60 target before the fundamental theme deteriorated somewhat.

Record US crude inventories, as well as increased production in countries excluded from the OPEC deals, such as Iran and Libya, nearly filled the 1.2MM  bpd supply gap left by those who participated in the deal. While the core theme of Saudi Arabia doing whatever it takes to avoid another oil market crash still stands, upside is now more limited. The new WTI range is likely to be $43-51 per barrel, with an outside chance of reaching the downside technical support level just below $40. I now have a 2017 Q2 price target of $46 WTI.

A moderated crude oil outlook has implications for the Fed’s monetary policy as it will allow inflation to plateau without the wheels coming off from a continued interest rate spike. Global central banks are being partially saved by shale oil producers in rural America. I expect a 25 bp hike tomorrow with no more than 1 or 2 more hikes this year. I also see the Fed beginning to reduce the size of its balance sheet in Q4, which along side energy price moderation, could even take a third hike for the year off the table.

The secular bond bull market may be behind us, but bond prices have fallen too far, too fast. Expect a short to medium term pause in bonds, especially if the 10y Treasury reaches 2.75% in the near term. A non-consensus, cautious long position in TLT or BLV is much more attractive now than it has been in months, but this is not a long term call by any means.

Finally, I expect some near term moderation in USD gains to turn into a mild pullback in the greenback after the Fed likely hikes the target rate tomorrow. The risk/reward for fresh long dollar positions is poor against nearly any cross, particularly NZD, JPY, and EUR. Wait for a more favorable dealing rate if you are chomping at the bit to get long USD.