Foreign Exchange & Commodities (July 2017)

Don’t Write Off The U.S. Dollar

“The greenback’s weakness due to unwinding of Trump trades since the start of 2017 seems to have gone a bit too far. The Fed hiked in June and seems intent on normalising policy. This should fuel modest renewed U.S. Dollar strength.”

– Michael Tan, Senior Portfolio Counsellor, OCBC Bank

  • Don’t write off the potential for mini U.S. Dollar rally as the Fed continues to normalise policy by hiking rates and shrinking its balance sheet.
  • The markets seem nervous that the Fed is making a policy error by tightening too quickly and/or planning to reduce its balance sheet too passively and automatically, given the doubts that persist about whether inflation will rise amid weakness in oil prices. But the core Fed leadership’s confidence in inflation picking up continues to underpin our view that markets are materially under-pricing the Fed’s rate path.
  • We expect gold to remain range bound in the next few months. Following the June Fed rate hike, gold retreated in response to the hawkish tilt in the Fed’s tone despite soft inflation data. Discussion around unwinding of the Fed's balance sheet likely also dismayed gold bulls. The decline in oil prices probably also drove the down move in gold by pressuring down inflation expectations and pushing up real yields.
  • We are not bullish on the gold price over a 12-month timeframe. We remain relatively comfortable with the view that U.S. GDP growth will accelerate from a depressed 1.2 per cent pace in 1Q2017 and the market is under-pricing the extent of Fed hikes.
  • Nevertheless, we recognise the value of the “hedge” trade and still believe holding gold as an “insurance policy” on global growth/geopolitical risks is prudent.
  • On oil, supply has been dragging prices lower. OPEC seems to be fighting a losing battle in its efforts to hold down supply and boost prices. Tension with Qatar casts doubts on the ability of the cartel to maintain discipline while inventories remain at unusually high levels. To make matters worse, demand is growing at the slowest pace in over two years.
  • The increased efficiency of U.S. shale producers means that they are profitable at ever lower prices. As a result the U.S. rig count has more than doubled from the lows of April 2016, and is back to levels last seen in early 2015. U.S. output has already recovered close to peak levels.
  • Short-term volatility is inevitable, but prices are constrained on the upside by the threat of output rising as more of the marginal producers become profitable. Meanwhile prices are limited on the downside as long as OPEC can enforce controls on excess supply. It looks as though the longer-term equilibrium price where supply and demand is in balance is around U$50 per barrel, which implies prices should be relatively stable around current levels.