U.S. Dollar Likely to Remain Under Pressure

Most of the market activity in the second half of this year has been driven by central bank expectations and the likelihood the Federal Reserve will begin cutting back on quantitative easing stimulus programs.  Any reductions in stimulus would likely put selling pressure on stock markets both in the U.S. and around the world, as this will weigh on corporate earnings forecasts and lead to downside revisions in the growth and consumer demand outlook.  At the same time, reductions in Fed stimulus would mean that the active currency supply running through the economy would decline.  This creates a bullish scenario for assets like the PowerShares DB US Dollar Index Bullish ETF (UUP), which tracks the value of the U.S. currency.

But recent events suggest that these reductions could be delayed longer than previously expected.  “Specifically, the government shutdown in the U.S. limits prospects for solid GDP growth in the fourth quarter,” said Rick Bartlett, currency analyst at CornerTrader.  “In addition to this, the government shutdown will postpone the release of critical economic data that the Fed will need before it can commit to any major changes in monetary policy.”  This means that prior market expectations of near-term tapering look increasingly unrealistic. These arguments are supported by the fact that the Fed has no real interest in ‘making waves,’ and adding to market volatility at a time when growth prospects are already being revised lower.

Focusing on Yield Plays

Prolonged stimulus programs in the U.S. will create a supportive outlook for the benchmark stock indices and high yielding currencies.  So, from a currency perspective, this puts assets denominated in the New Zealand or Australian Dollar in a bullish context, as interest rates in both countries are seen at 2.5% (well above what is seen in most regional counterparts).  This means that investors holding assets denominated in these currencies will be able to generate yield gains even if we see enhanced market volatility into the final months of the year.

Low yielding currencies like the U.S. Dollar and Japanese Yen are likely to under-perform in these types of environments.  So the main question going forward will be whether or not the Federal Reserve is truly spooked by the potential economic hindrances that have arisen as a result of the government shutdown.  For these reasons, investors will need to pay more attention to public commentaries released by voting members of the central banks.  These releases now have the potential to move markets more than individual data releases, so even reports like the monthly Non Farm Payrolls figures (which will be released next Tuesday — an alteration from the regular scheduled) could be relegated to the back burner.  Employment numbers that are particularly strong could lead to discussions of earlier stimulus reductions.  But ETF investors must remain cognizant of these trends, as there is little reason to be bullish on the PowerShares DB US Dollar Index Bullish ETF in the near-term.