Grant's Interest Rate Observer: A Dollar Rally Imminent?

Uncle Sam is feeling his oats. Friday morning brought a brisk reading of third quarter advance GDP growth, with annualized sequential gains of 3.0%, well above the economist consensus of 2.6%. In tandem with the 3.1% pace of output growth in the second quarter, last week’s reading marked just the third instance of consecutive three-handle GDP prints since the end of 2004. Taking in the news, interest rate futures markets rendered their verdict:  A rate hike is probably imminent.  Futures currently price 84% likelihood of policy tightening at the Fed’s Dec. 13 meeting, little changed from last week.  

 

The solid output and upward trajectory in U.S. short term interest rates (recent charts of three-month Libor or two-year Treasury note yields resemble that of a FAANG stock) is increasingly diverging from that of the eurozone, where growth is slower and rates lower.  Euro area GDP growth has also managed some modest acceleration, printing 2.3% year-on-year in the second quarter (its best showing since 2011), but has yet to reach 3% in any single quarter since the financial crisis.  Third quarter statistics are set to be released tomorrow. 

 

The interest rate differential is even starker.  While the 10-year Treasury note currently fetches lenders a modest 2.37% per annum, 10-year German bunds yield a paltry 0.38%, which Bloomberg notes is the largest interest rate spread between the two countries since the Berlin Wall came down.  Spain, which is facing an existential crisis featuring the potential secession of its most prosperous region (Catalonia), borrows for 10 years at a rate of 1.51%. 

  

Better growth and higher interest rates in the U.S. than Europe have not been reflected in the currency markets.  The euro, which traded at $1.04 into year-end, has rallied against the greenback for the bulk of 2017 and currently fetches $1.16 after a recent pullback.  More broadly, the U.S. Dollar Index (DXY), which was the recipient of a friendly word in the Aug. 8 edition of Almost Daily Grant’s (“The buck stops here”), is still down by more than 8% this year even after a 3.5% bounce since the beginning of September.  

 

Current positioning could prove a tailwind for dollar bulls if the rebound persists.  According to the Oct. 17 Commitment of Traders Report from the Commodity Futures Trading Commission, noncommercial (i.e., speculative) short contracts outstanding in the DXY easily exceeded noncommercial longs.  The last time that happened was May 2014, after which the Dollar Index enjoyed a 25% rally through the spring of 2015.

 

There are of course risks to the dollar appreciation case.  Carl Weinberg, chief economist and managing director at High Frequency Economics, articulated a perhaps-unlikely but certainly unpleasant hypothetical for dollar bulls in a recent appearance on CNBC: “I believe that yuan pricing of oil is coming and as soon as the Saudis move to accept it – as the Chinese will compel them to do – then the rest of the oil market will move along with them. . . Moving oil trade out of dollars into yuan will take right now between $600 billion and $800 billion worth of transactions out of the dollar.”