US Assets Taking Divergent Paths: Stocks Look Healthy, the Dollar Doesn’t

With only five weeks left in the year, 2017 is nearly a relic of the past. The US Dollar will probably be thankful for turning the calendar to 2018; it has been a disappointing year to say the least. After hitting its high on the first trading day of 2017, the DXY Index hit a yearly low on September 8 and has only rebounded marginally since then.

On the other hand, 2017 has been another great year for bonds and stocks: US Treasury yields at the long-end of the curve continue to fall, even as US equity markets pushed relentlessly higher. In fact, during the week of Thanksgiving in the United States, all three major US equity markets hit new intraday all-time highs.

These trading conditions that have been the hallmark of not only the first two months of the fourth quarter but 2017 in general appear to be destined to continue through the end of the year. As such, we’re watching three major themes as the next five weeks wind down into 2018:

1. The Disagreement Between the Fed and the Market Over the Path of Rate Hikes

The biggest threat to the US Dollar through the end of the year, and well into 2018, is the prospect that the Federal Reserve is wrong. Since December 2016, it has been projected three rate hikes during the next calendar year. However, market participants disagree: only one 25-bps hike is being priced-in, currently for June 2018.

This dissonance between the Fed’s point of view and the market’s perception of Fed policy is the most considerable source of concern for the greenback. As we saw after the Fed kicked off the rate hike cycle in December 2015, the frequent habit of reducing the projected path of future interest rate hikes (the “glide path”) proved to undermine the US Dollar for nearly all of 2016.

2. Low Inflation Means Stocks Can Keep Climbing, Bond Yields Can Stay Low

First, some corporate financial theory. When corporations are planning expenditures, a stable investment environment is preferred. Stability yields confidence in financial forecasts, reducing uncertainty about returns. In theory, reduced uncertainty should translate into greater investment – more risk taking – by corporations.

Stable, low inflation is an outcome that corporations can live with – and flourish under. Yes, costs are indeed rising. But they are rising at a predictable, manageable rate. Costs can be projected with confidence, meaning capital can be deployed into projects that generate revenue and earnings growth.

Something similar can be said about bonds. If inflation expectations are rapidly increasing, you would expect to see fixed income underperform: why would you want to have a fixed return when prices are increasing? On a real basis, your returns would be lower than otherwise intended.

3. Tax Reform Should be a Positive, but It Doesn’t Feel That Way

Since 1965, there have only been 18 years in which one party has controlled both Congress and the White House. Regardless of ideology, whichever singular party has tended to be in control after a wave election has pursued fiscal easing strategies: the US budget deficit grew by an average of 0.4% of GDP during those 18 years. Historically, it's been observed that when the US government runs larger deficits, inflation tends to increase.

Enter the current tax reform plan: it is expected to grow the deficit by $1.5 trillion over the next decade. Accordingly, the implication is that passage of tax reform legislation will lead to a rise in expected as well as realized inflation, forcing the Fed into a more hawkish monetary stance (i.e. keeping up the three hike per year pace of rate increases), and ultimately, forcing the market to believe the Fed (Fed has said three hikes are coming in 2018; market is only pricing in one for June 2018). 

Yet now that Republicans are trying to tie some aspects of their failed bid to reform the healthcare system into tax reform, it is a possibility that tax reform isn’t passed at all. In that scenario, the outlook is still strong for stocks and bonds (low inflation, improving global growth, and strong corporate earnings) but worrisome for the US Dollar (diminished prospect for an inflation bump in the future).