Two Virtuous Dollar Circles

The appearance of two virtuous circles will cause the real broad trade-weighted dollar to strengthen by 10% over the next 12 months. The Fed's efforts to run a "high pressure" economy will create a self-reinforcing cycle where accelerating wage growth boosts household spending, leading to faster wage growth and even more spending. Stronger growth will prompt the market to price in more rate hikes over the coming years, propelling the dollar higher.

SHARE

On LinkedIn
On Twitter
 

The first virtuous circle will push up real yields in the U.S., while the second will push down real yields in key economies such as Europe and Japan. Taken together, this will cause real yield differentials to widen sharply in favor of the U.S., sending the greenback higher.

Virtuous Circle #1: Accelerating wage growth boosts U.S. consumption, leading to even faster wage growth and more spending. This forces the Fed to hike rates more than what the market is currently discounting.

Real personal consumption has grown by 3% since mid-2013, even as the rest of the economy has expanded by a middling 0.7%. Most analysts expect consumption growth to decelerate next year to around 2.4%, based on Bloomberg estimates (Chart 1).

Chart 1

There is no shortage of reasons for why consumer spending may slow. The drop in energy prices since mid-2014 has saved households an annualized $120 billion at the pump, and an additional $30 billion in the form of lower utility bills - equivalent to around 1% of disposable income. This has given households scope to increase spending on other items. Now that oil prices appear to have bottomed, this windfall will cease to grow.

To access the full article request a demo or if you are already a BCA client, login here.