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The Dollar Rounds on Doubters after GDP Data Challenges Federal Reserve Rate Cut Narrative

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- USD advances after growth surprises to the upside in second quarter. 

- Consumer spending offsets lesser exports and business investments.

- Fed 'easing cycle' is not necessary, says CIBC, eyes "insurance" cuts.

- USD bears set to retreat as large July cut priced-out of bond market.

The Dollar extended gains over rivals Friday after official data showed the economy growing faster than was expected during the second-quarter, challenging a consensus suggesting America is headed for the rocks and promting investors to rethink earlier bets that the Federal Reserve (Fed) is on the verge of an 'easing cycle'.

U.S. GDP growth was 2.1% in the second-quarter, down from 3.1% in the opening quarter but ahead of the market consensus for a 1.8% expansion. The beat against expectations was the result of strong consumer and government spending compensating for weakness elsewhere. 

The numbers mean the quarterly pace of U.S. GDP growth averaged 2.6% in the first-half of the year, which is above the 2.4% average seen in the last five years, according to Pantheon Macroeconomics

"So much for the first half rollover in the U.S. economy," says Ian Shepherdson, chief U.S. economist at Pantheon. "Expect economy bears to focus on the soft capex numbers, while bulls will cite the strength of consumption, which accounts for nearly 70% of GDP." 


Above: Pantheon Macroeconomics graphs showing quarterly GDP growth rates.

"What dragged down overall GDP growth was a big drag from inventories, which subtracted 0.9% points from GDP growth, and net external trade, which subtracted 0.7% points. Exports contracted by 5.0%, while imports edged up by 0.1%," says Paul Ashworth, chief U.S. economist at Capital Economics.

Financial markets have worried about the state of the U.S. economy in recent months after a May escalation of the trade war with China saw threatened to exacerbate an ongoing slowdown in growth elsewhere in the world. These concerns have seen the financial community rapidly begin to position for a series of Federal Reserve rate cuts.

However, Friday's data suggests those concerns may have been overdone and could yet impact the Wednesday, 31 July interest rate decision from the Fed. Markets are betting the house the Fed will cut rates next week but are unsure whether it will reduce the cash rate by 25 basis points or 50 basis points. It's currently 2.5%. 

There was never much hard evidence of a major turn lower by the economy heading into Friday's release. Official data has shown industrial firms struggling amid a litany of trade skirmishes including the June confrontation with Mexico over the southern border, but beyond that there's been little to suggest trouble ahead. 

"Do you call that a slowdown?," asks Avery Shenfeld, chief economist at CIBC Capital Markets. "We are headed for only a couple of quarter point insurance cuts from the Fed, rather than a major easing cycle."


Above: Dollar Index shown at daily intervals.

"None of this will matter next week, when the Fed cuts by 25bp, but the more data we see, the more that one-and-done makes much more sense than continued easing," writes Pantheon's Shepherdson, in a note to clients following the release.  

Currency markets care about the GDP data because it reflects rising and falling demand within the US economy, which has a direct bearing on consumer price inflation, which is itself important for questions around interest rates. And interest rates themselves are a raison d'être for most moves in exchange rates.

Changes in interest rates are normally only made in response to movements in inflation, which is sensitive to growth, but impact currencies because of the push and pull influence they have over capital flows. 

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

"We had anticipated an even more pronounced drop off to 1.6% (consensus 1.8%) and the breakdown of growth was also more encouraging than we had expected. In short, this slowdown just about justifies a 25bp cut by the Fed next week, but the chances of a bigger 50bp reduction just receded further," says Ashworth of Capital Economics.

Above: Pound-to-Dollar rate shown at Daily intervals.

"Our baseline remains that the US dollar should turn lower into 2H, driven by Fed cuts and economic convergence. But the dollar has remained remarkably firm due to recently weak external and solid US data. Renewed economic divergence and reduced Fed easing expectations could further support the dollar ahead," says Ben Randol at Bank of America, in a recent note to clients. "Our 4Q EUR/USD and USD/JPY forecasts are 1.17 and 101, respectively."

The Federal Reserve raised its interest rate four times in 2018 as the U.S. economy expanded at an increased pace, aided by White House tax cuts, and inflation rose above the 2% target.

It has now lifted rates nine times since the end of 2015 but inflation has recently fallen below the target and growth is now expected to slow as global growth decelerates in response to the White House trade war with China.  

Global growth is slowing due to damage done by the trade war to business confidence as well as the Chinese and Eurozone economies. That slowdown has forced other central banks to either cut rates, or consider doing so. 

The combination of Fed rate hikes, coming against a backdrop of central bank cuts elsewhere in the world, helped lift the Dollar Index by 4% last year. Since then many analysts have penciled in large declines for the Dollar, which are seen playing out as the Fed cuts, but so far those losses have been few and far between in number.

"What supports a rate cut is the weakness in global manufacturing activity, and the threat of an escalation in trade tensions. A 25bps cut is already priced in by the markets. Communicating future cuts will be key. A 50bps cut would be negative for the dollar, as even if the Fed says it is a oneoff move, the market may choose not to believe it and expect cuts over and above the 100bps priced in until end-2020," says Gaétan Peroux, a strategist at UBS.


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