Fundamental Analysis of the USD
Monday, 20 May 2024, Week 21: This report provides a fundamental analysis of the USD and is structured to provide a comprehensive overview of the current market dynamics and their potential implications for the USD.
The report is intended for use by Forex traders seeking to understand the fundamental factors driving the USD's value and to inform their trading decisions.
GEOPOLITICS and RISK TOLERANCE IN US MARKETS
The global landscape remains fraught with geopolitical uncertainties, significantly impacting market sentiment and risk tolerance among financial market participants. The most severe event of the past five months is the ongoing Israel-Hamas war, which escalated in October 2023. This conflict has heightened geopolitical tensions in the Middle East, disrupted energy markets, and triggered safe-haven flows into assets like gold, the Swiss franc, and the Japanese yen.
China's ongoing property market crisis, marked by declining sales and rising developer defaults, has also weighed on market sentiment. The crisis has dragged on China's economic growth, weakened commodity prices, and raised concerns about potential global financial contagion.
The shifting US monetary policy outlook, with recent data suggesting a slowdown in inflation, has fuelled expectations of a policy pivot towards rate cuts, injecting volatility into markets. The US dollar has experienced significant volatility as traders adjust their expectations about the timing and magnitude of potential rate cuts.
The US-China strategic competition, encompassing trade, technology, security, and geopolitical influence, has also increased risk aversion among investors. Trade tensions, technology competition, and geopolitical instability arising from this rivalry have contributed to market volatility.
Finally, the death of Iranian President Ebrahim Raisi in a helicopter crash in May 2024 has created uncertainty about the country's political future and its foreign policy stance. This event has injected volatility into oil markets and weighed on regional currencies.
These risk events have created a challenging environment for financial market participants, requiring careful monitoring and proactive risk management strategies.
U.S. FISCAL POLICY
The US fiscal policy landscape over the past five months has been shaped by ongoing economic challenges, geopolitical uncertainties, and the President's ambitious policy agenda outlined in the Fiscal Year 2025 budget. The US government has made notable progress in reducing the budget deficit, exceeding expectations for 2023. The President's Fiscal Year 2025 budget proposes further deficit reduction measures, aiming to achieve $3 trillion in deficit reduction over the next ten years.
This commitment to fiscal responsibility and deficit reduction can strengthen the USD, as it signals a more stable and sustainable fiscal outlook. Lower deficits can lead to lower bond yields, as investors perceive less risk associated with US government debt. A more stable fiscal environment can create a more favourable backdrop for stock market growth, as it reduces uncertainty and supports business confidence.
The President's Fiscal Year 2025 budget also proposes significant investments in key areas, including childcare, education, healthcare, clean energy, and infrastructure. These investments aim to boost economic growth, create jobs, and address long-standing social and economic challenges.
The impact of these investments on the USD is multifaceted. In the short term, increased government spending could weaken the dollar. However, in the long term, if the investments lead to higher economic growth and productivity, they could strengthen the dollar. The proposed investments could benefit specific sectors of the stock market, such as clean energy, infrastructure, and healthcare. However, concerns about potential tax increases to fund these investments could weigh on overall market sentiment. Investments in clean energy and infrastructure could boost demand for certain commodities, such as copper, lithium, and steel.
The US government debt to GDP ratio reached 122.30% in 2023, exceeding the Trading Economics' forecast of 124.30%. This suggests that the US government's efforts to reduce the deficit have had a more significant impact than initially anticipated. Trading Economics' long-term projections indicate a continued upward trend, with the ratio expected to reach 126.40% in 2025 and 127.80% in 2026. However, these projections predate the release of the Fiscal Year 2025 budget, which outlines substantial deficit reduction measures.
The President's Fiscal Year 2025 budget proposes to reduce the deficit by $3 trillion over the next ten years through a combination of spending cuts and revenue increases. These measures include allowing Medicare to negotiate prices on more drugs, cutting wasteful subsidies, introducing a minimum tax on billionaires, increasing the corporate minimum tax rate, quadrupling the surcharge on stock buybacks, and extending IRS investments to crack down on tax cheats.
The likelihood of achieving the proposed deficit reduction targets depends on several factors, including Congressional approval, economic growth, and geopolitical stability. Overall, the US government debt to GDP ratio remains a key indicator to monitor for Forex traders. While the latest data has performed better than expected, the ratio remains elevated, and its future trajectory will depend on the effectiveness of the proposed fiscal policies and the broader economic and geopolitical environment.
U.S. ECONOMY
The US economy is showing signs of slowing down, with Q1 2024 GDP growth coming in at an annualized rate of 1.6%, below market forecasts of 2.5%. This marks the lowest growth rate since the contractions in the first half of 2022 and represents a significant deceleration from the 3.4% growth recorded in Q4 2023.
The slowdown in economic growth is attributed to weakening consumer spending, easing non-residential investment, slowing government spending, a sharp slowdown in exports, and soaring imports. This slowdown is likely to weigh on the USD in the longer term, as it could lead to a less hawkish Federal Reserve. The slowdown in economic growth could also weigh on corporate earnings, potentially leading to a correction in the stock market. It could also lead to lower bond yields, as investors seek safe-haven assets. Finally, the slowdown in global demand could weigh on commodity prices, particularly for industrial metals.
The latest GDP data has underperformed against expectations, coming in below the 2.5% forecast. Trading Economics' long-term projections indicate that the US GDP growth rate is expected to trend around 1.8% in 2025. However, the likelihood of achieving this projection will depend on several factors, including consumer spending, business investment, and Federal Reserve policy.
The US labour market remains tight, but there are signs of weakening. The unemployment rate edged up to 3.9% in April 2024, from 3.8% in March, surprising market expectations which had forecasted the rate to remain unchanged. The US economy added 175,000 jobs in April 2024, a deceleration compared to the upwardly revised 315,000 jobs added in March and falling short of market expectations for a 243,000 increase. Average hourly earnings for all employees on US private nonfarm payrolls edged up by 7 cents, or 0.2%, to $34.75 in April 2024, after a 0.3% increase in the prior month and below market estimates of a 0.3% rise.
The labour market is being impacted by slowing economic growth, rising interest rates, and inflation. A weakening labour market could lead to a less hawkish Federal Reserve, which could weigh on the USD. It could also lead to a slowdown in consumer spending, which could weigh on corporate earnings and stock prices. Additionally, it could lead to lower bond yields, as investors seek safe-haven assets.
The unemployment rate surprised market expectations by ticking up to 3.9% in April. Trading Economics' global macro models and analysts expect the unemployment rate to reach 4.0% by the end of Q2 2024. Trading Economics' econometric models project that US non-farm payrolls will trend around 170,000 in 2025. The slowdown in average hourly earnings growth suggests that wage pressures may be easing, which could be a positive development for inflation. However, it is important to note that wage growth remains above the Fed's 2% inflation target.
Inflation in the US has eased slightly, but remains above the Federal Reserve's 2% target. The annual inflation rate eased to 3.4% in April 2024 from 3.5% in March, in line with market forecasts. The annual core consumer price inflation rate, which excludes volatile items such as food and energy, eased to a three-year low of 3.6% in April 2024, down from 3.8% in the prior month, matching market forecasts.
The easing of inflation is attributed to easing supply chain disruptions, lower energy prices, and Federal Reserve policy. Easing inflation could lead to a less hawkish Federal Reserve, which could weigh on the USD. It could also be positive for stocks, as it could lead to higher corporate earnings. Additionally, it could lead to lower bond yields, as investors perceive less risk of inflation eroding the value of their investments. Finally, easing inflation could weigh on commodity prices, as it could lead to lower demand.
The inflation rate eased to 3.4% in April, in line with market forecasts. Trading Economics' econometric models project that the US inflation rate will trend around 2.4% in 2025. The easing of core inflation is a positive development, as it suggests that underlying inflationary pressures may be abating. However, core inflation remains above the Fed's 2% target, so the Fed is likely to remain cautious about easing monetary policy too quickly.
The US trade deficit remains elevated, but the current account deficit has narrowed. The trade deficit in the US remained almost unchanged at ten-month highs of $69.4 billion in March 2024, compared to an upwardly revised $69.5 billion in February and forecasts of a $69.1 billion deficit. The US current account deficit narrowed by 15.7% to $818.8 billion in 2023, mostly reflected a reduced deficit on goods. The current account gap was equivalent to 3.0% of current-dollar GDP, down from 3.8% in 2022. Exports of goods and services from the United States declined by $5.3 billion to $257.6 billion in March 2024, down from February's record high of $262.9 billion. Meanwhile, imports into the United States decreased by $5.4 billion, or 1.6%, from the previous month to $327 billion in March 2024.
The persistence of the trade deficit is attributed to the strong USD, robust domestic demand, and global supply chain disruptions. A persistent trade deficit can weigh on the USD, as it suggests that the US is relying on foreign capital to finance its consumption. It can also be negative for US companies that compete with imports, as it could lead to lower sales and profits.
The trade deficit remained almost unchanged at $69.4 billion in March, defying market forecasts of a $69.1 billion deficit. Trading Economics' global macro models and analysts expect the US trade balance to reach -$67.0 billion by the end of Q2 2024. Trading Economics' global macro models and analysts expect the US current account to reach -2.8% of GDP by the end of 2024. The decline in both exports and imports suggests that trade activity may be slowing, which could be a reflection of the slowdown in global economic growth.
U.S. and INTERNATIONAL MARKETS
The USD has experienced significant volatility in the forex market over the past five months, influenced by shifting expectations regarding US monetary policy, global economic growth concerns, and persistent geopolitical tensions. The USD initially strengthened as the Federal Reserve embarked on an aggressive interest rate hiking cycle to combat surging inflation. However, recent economic data suggesting a slowdown in inflation and economic growth has fuelled expectations of a policy pivot towards rate cuts, injecting volatility into the USD. The USD has weakened against most major currencies in recent weeks as market participants price in the likelihood of Fed rate cuts later this year. The ongoing Israel-Hamas war and the US-China strategic competition have also contributed to USD volatility, triggering safe-haven flows into the USD during periods of heightened risk aversion.
The US stock market has also experienced significant volatility over the past five months, driven by shifting expectations regarding US monetary policy, economic growth concerns, and geopolitical tensions. Initially, the stock market rallied as investors anticipated a continued economic expansion and strong corporate earnings. However, the Federal Reserve's aggressive interest rate hikes to combat inflation have raised concerns about a potential recession, weighing on stock prices. The prospect of Fed rate cuts has provided some support for the stock market in recent weeks, as lower interest rates can stimulate economic growth and boost corporate earnings. However, the ongoing Israel-Hamas war and the US-China strategic competition continue to create uncertainty, contributing to stock market volatility.
US government bond yields have fluctuated over the past five months, driven by shifting expectations regarding US monetary policy, inflation, and economic growth. Initially, bond yields rose as the Federal Reserve embarked on its interest rate hiking cycle, pushing up borrowing costs across the economy. However, recent economic data suggesting a slowdown in inflation and economic growth has fuelled expectations of a policy pivot towards rate cuts, leading to a decline in bond yields. The prospect of Fed rate cuts has pushed bond yields lower, as investors anticipate a decline in borrowing costs. The ongoing Israel-Hamas war and the US-China strategic competition have also contributed to bond market volatility, triggering safe-haven flows into US government bonds during periods of heightened risk aversion.
Commodity prices have been volatile over the past five months, driven by shifting global economic growth prospects, supply chain disruptions, the war in Ukraine, and the USD's performance. The USD's strength earlier in the year weighed on commodity prices, as it made dollar-denominated commodities more expensive for buyers using other currencies. However, recent USD weakness has provided some support for commodity prices. The ongoing Israel-Hamas war has injected volatility into energy markets, as Israel is a key energy producer in the region. The war in Ukraine continues to disrupt global commodity markets, particularly for agricultural products and energy. The slowdown in global economic growth has weighed on demand for industrial metals, contributing to price declines.
MONETARY POLICY
The Fed opted to maintain the target range for the federal funds rate at 5.25% to 5.50% during its May meeting, marking the sixth consecutive pause in its tightening cycle. This decision reflects the FOMC's assessment that inflation, while moderating, remains elevated, and further progress toward the 2% target is not assured.
The Fed's current monetary policy stance is characterized by a commitment to bringing inflation back down to its 2% target while balancing the risks to economic growth and employment. The FOMC has signaled that it will maintain a restrictive policy stance for as long as necessary to achieve its inflation objective.
The Fed's shift to a restrictive monetary policy stance was driven by surging inflation, which reached multi-decade highs in 2023. The FOMC initiated a series of aggressive interest rate hikes, starting in March 2023, to curb inflationary pressures. The Fed's hawkish stance was also influenced by a tight labour market, characterized by low unemployment and strong wage growth.
The Fed's target range for the federal funds rate currently stands at 5.25% to 5.50%. The Summary of Economic Projections released in March 2024 showed that FOMC participants' median projection for the federal funds rate at the end of 2024 was 4.875%. Trading Economics' global macro models and analysts expect the Fed Funds Rate to remain at 5.50% by the end of this quarter. In the long-term, the Fed Funds Rate is projected to trend around 4.25 percent in 2025 and 3.25 percent in 2026, according to their econometric models.
The likelihood of achieving these projections will depend on several factors, including the inflation trajectory, economic growth, and labour market conditions. Overall, the Fed's current monetary policy stance is data-dependent, and the future path of interest rates will be determined by the evolution of inflation, economic growth, and labour market conditions.
CONCLUSION
The USD faces a confluence of opposing forces. The US economy is slowing, inflation is moderating, and the Federal Reserve is expected to pivot towards rate cuts in the coming months. These factors are likely to weigh on the USD in the medium to long term. However, the USD remains supported by safe-haven demand stemming from persistent geopolitical uncertainties, including the ongoing Israel-Hamas war and the US-China strategic competition.
For Forex traders, the USD's outlook presents both opportunities and risks. The potential for USD weakness could create opportunities for traders to short the USD against other currencies. However, the USD's safe-haven status could limit the extent of any USD depreciation, particularly during periods of heightened global risk aversion.
Traders should closely monitor economic data releases, FOMC communications, and geopolitical developments to assess the evolving balance of factors influencing the USD's value. A data-dependent approach, combined with robust risk management strategies, will be crucial for navigating the USD's uncertain trajectory in the coming months.