Morgan Stanley Has Four Reasons Why It's Different This Time for the U.S. Dollar
Another year, another King Dollar thesis.
Expectations for a strengthening U.S. dollar are high once again, with strategists at banks including Goldman Sachs Group Inc., Bank of America Merrill Lynch and Morgan Stanley all predicting more strength ahead in 2017 for the greenback, which recently hit its highest levels since 2003.
It's a familiar call on Wall Street, which last year predicted that diverging monetary policy expectations would propel the dollar upwards. Instead, risk appetite deteriorated at the start of the year and the U.S. dollar fell out of bed from February through April, with the spot index ultimately spending the vast majority of the first three quarters of the year underwater on an annual basis.
"The S&P 500 fell by 8 percent in the first 12 trading days of 2016 as oil, Treasury yields and [the Chinese yuan] raced to see who could fall the farthest, the fastest," recalls Andrew Sheets, chief global cross asset strategist at Morgan Stanley. "The case for further rate hikes was scuttled, the dollar rolled over and, by mid-February, you couldn't give bank stocks away."
And when questioned about why history won't repeat itself in 2017, Sheets answers with the four scariest words in finance: this time is different.
The strategist offered four reasons why in a note to clients on Sunday.
1. Manufacturing is back
Now, he observes, the U.S. and global economies are firing on more cylinders. Whereas the manufacturing sector stateside was sliding into recession at the end at 2015, the ISM Manufacturing PMI broke above 53 in November to match its highest reading of the year.
In addition, U.S. inventories have been drawn down and global trade appears to be bouncing back, according to the strategist, though the incoming regime in Washington, D.C. has the potential to undermine this nascent trend.
2. Marching towards the mandate
"Both the unemployment rate and jobless claims are lower today than this time last year and moving in a better direction," adds Sheets.
The headline unemployment rate had been moving sideways throughout 2016 before a sharp dip in November's report. As such, the trend in the broader 'U6' unemployment rate, which includes the unemployed as well as those employed part time for economic reasons and those marginally attached to the labor force, better demonstrates the evolving improvements in the job market.
This metric was flat in its last few readings of 2015, but has improved notably in the past two non-farm payroll reports.
3. Rising inflation expectations
Market-based measures of inflation expectations, meanwhile, are rising amid firming commodity prices and the presumption that fiscal stimulus will soon be on the way in the U.S. The hopes that major oil producers will follow through on a deal to cut output, which are currently buoying oil prices, would also likely provide some support for inflation expectations, should the rally endure.
Though the surge in bond yields has captured investors' attention, the rise in inflation expectations implies that real interest rates have gone up by much less than nominal Treasury yields. This suggests that the rise in rates hasn't reached a point where it will hamper real economic activity or dampen risk appetite, Sheets reckons.
"Real yields today are still [circa] 25 basis points lower than where they were in late 2015, suggesting there is still some leeway before the yield rise is disruptive to the market overall," he concludes.
4. But a still-slow Fed
The kicker: despite evidence of firming growth all over the world, the improvement in domestic economic conditions central to the Fed's mandate, and the continuation of accommodative financial conditions, "the market today expects the Fed to move more slowly over the coming 12 months than it did last year," Sheets claims. "A low bar makes it more likely that the Fed meets — or exceeds — expectations, supporting the U.S. dollar."
Morgan Stanley is forecasting six rate hikes between today and the end of 2018, an amount in line with the median Fed official's dot from the most recent Summary of Economic Projections but above the level implied by overnight index swaps.
"There are a number of ways our crowded view on the dollar could be wrong," admits Sheets. "But if the Fed moves six times between now and end-2018, we think it can be right."