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Dollar Declares Itself King as Markets Rise on Hopes of Tax Cuts 2.0 and German Stimulus


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- USD bests most G10 rivals on hopes of U.S. and German stimulus.

- Markets eye tax cuts 2.0 and an abandonment of German austerity.

- But Fed looms large this week and will set USD direction up ahead. 

- Some say Fed is apt to disappoint market and Trump, buoying USD.

The Dollar rose against all barring two of its G10 rivals Monday as investors responded to claims that two of the world's top economies are contemplating fiscal stimulus at a time when the global economy is wounded and weakening fast, although much about the future direction of the U.S. currency will be determined in the weeks ahead by the Federal Reserve (Fed). 

President Donald Trump's top economic adviser Larry Kudlow told Fox News Sunday "there's no recession in sight" and that the White House is examining what room there might be for another round of tax cuts to help sustain the economic expansion, little more than a year after the first round proved so succesful in lifting U.S. growth. Hic comments came just days after the first U.S. 'yield curve inversion' since the crisis led to a palpable amplification of market fears about the odds of a recession up ahead.

This, and speculation about a similar kind of stimulus in Germany that could aid the austerity-stricken and struggling European economy, prompted a bid for so-called risk assets on Monday and sent 'safe-havens' tumbling. It also supported the Dollar, much to the ire of President Donald Trump, who criticised Federal Reserve policy on Twitter again during the noon session and advocated for 100 basis points worth of rate cuts "over a fairly short period of time".

"We rather think that given the limitations that monetary policy has neared (see Japan for example), fiscal may become a more prominent feature among the major economies," says Mazen Issa, a strategist at TD Securities

Above: GBP/USD at hourly intervals, and VIX 'fear index' (green), gold price (blue) and oil (orange)

"We think downward-sloping trend-line resistance (currently in the 1.2130-50s) will be the pivot for price action this week heading into Jerome Powell’s speech on Friday.  Staying below this level should keep the pressure on whereas a NY close above the level could give the extended fund short position something to think about," says Eric Bregar at Exchange Bank of Canada.

Kudlow's comments also came in the wake of a string of media reports published over the course of last week that suggested the German government is contemplating abandoning the balanced budget policy that's underwritten its appetite for austerity in recent years. Any shift away from the 'fiscal tightening' stance would be a boon for the struggling German economy, which some say risks a recession this year, and the Euro as well because Germany accounts for a significant portion of Eurozone output.

If running concurrent with a second round of U.S. tax cuts, this stimulus could prove to be a watershed moment for the global economy, which has weakened as the slowdown in China resulting from the trade war has steadily been felt in other parts of the world. Most notably, in Germany, where the manufacturing sector had bet big on the Chinese luxury car market in recent years and where the bilateral trade relationship has been significant for some time. 

"Markets broadly celebrated this potential for further stimulus and it gave EURUSD, in particular, a chance to regain trend-line support at the 1.1100 level.  The NY close however (slightly below 1.1100) was far from convincing to scare EUR shorts in our opinion and when we combine this with comments out of the Bundesbank this morning about it seeing a risk that Germany entering a recession, it’s not surprising to still see EURUSD on the defensive," says Exchange Bank of Canada's Bregar

Above: Euro-to-Dollar rate shown at daily intervals alongside the Dollar Index (green line, left axis).

Germany's Finance Minister, Olaf Scholz, said Sunday during a ministry 'open day' speech the government could mobilise as much as €50 bn (£45 bn) of taxpayer funds to spend in order to stimulate the economy if such assistance becomes necessary, which is equivalent to around 1.5% of GDP. Such a step is being billed as marking an end to Germany's long-running commitment to running a budget surplus. 

Scholz's comments came barely a week after Handelsblatt reported the government is contemplating abandoning the balanced budget policy, dubbed 'black zero' in the local press, in order to fund efforts aimed at addressing climate change with September 20 floated as the likely date of any announcement. However, it's not clear how much of this kind would be spent within Germany, which would be necessary if the funds are to boost the economy. 

Central bankers the world over have been calling for governments to break with the post-crisis penchant for austerity by using fiscal policy in order to get their economies going, given many of them have already pushed their interest rates to levels which are so low that further rate cuts are now seen as being only of limited use. The most notable example is the European Central Bank (ECB).

"Powell’s speech this Friday is far and away the most important event risk for markets this week Powell has been beset with criticism," says John Hardy, chief FX strategist at Saxo Bank. "A real turn lower in the USD likely requires the Fed to cut more sooner and restart massive QE. Is Powell ready to go there and re-enact Bernanke’s famous 2010 Jackson Hole performance (which pre-announced QE2) or will he remain behind the easing curve?"

Above: Pound-to-Dollar rate shown at daily intervals alongside the Dollar Index (green line, left axis).

"We think this week's Jackson Hole Symposium may telegraph a reluctance to deliver as much easing than markets are currently pricing (~65bps this year and another ~25bps in 2020)," says TD's Issa. "Fed speak in recent weeks has been firmly indicative that the Committee is less cavalier on easing potential, let alone the future path of policy, than fed fund futures and the Treasury curve."

Monday's price action comes days ahead of an eagerly-anticipated speech titled "Challenges for Monetary Policy" that's due to be delivered by Fed Chairman Jerome Powell at the annual Jackson Hole Symposium at 15:00 on Friday. This is almost certain to impact the Dollar but nobody knows whether the effect will be for better or worse. Many say Powell has his work cut out for him in order to weaken the Dollar, while few are actually forecasting a decline for the U.S. currency in the short-term.

The Fed's four 2018 rate hikes took the Fed Funds rate up to a post-crisis high of 2.5% and significantly boosted the attractiveness of U.S. government bonds in the eyes of investors, right at a time when American economic momentum was building off the back of White House tax cuts that came into effect at the beginning of last year. That incentivised investors to sell assets in lower-yielding parts of the world like Europe and to buy Dollars instead, leading the Dollar index to rise 4% last year and 2% in 2019. 

"The market will be focused on any hints at further easing/any new dovish comments from the various FOMC members," says Petr Krpata, a strategist at ING. "The hopes for more insurance easing coming from the Fed should provide some support to risk currencies this week and translate into a limited upside to USD. DXY should not breach the 99 level."

Above: Dollar index shown at daily intervals, and annotated for recent events.

U.S. bonds still pay a darn sight more in yield than those in Europe, even after the Fed decided on July 31 to cut its interest rate to 2.25%. Some analysts say this explains why the Dollar has not yet declined relative to many of its rivals and that much steeper cuts, as well as a pickup in economic momentum overseas, will be required in order to knock the U.S. currency off its perch as king of the developed world currency market. 

For its part, the Fed says it cut rates in July due mainly to the deteriorating condition of the global economy, which has been hurt by the trade war. Fears on the Federal Open Market Committee have always been that a global downturn will eventually hurt the U.S. economy through reduced demand for products made in America, although it's constrained in the extent to which it can act by the elevated level of U.S. inflation and its statutory mandate to use interest rate policy to keep price pressures contained. 

Changes in 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. Those 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.  

"One downside of additional fiscal stimulus would be that it would encourage an even stronger US dollar," says MUFG's Hardman. "The US dollar will likely strengthen further this week if Fed Chair Powell fails to display a dovish tone."

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