The US dollar has further to fall – which is good news for markets

The US Federal Reserve still plans to raise interest rates further this year.

It's also looking at shrinking its balance sheet (ie, going some way towards reversing quantitative easing).

That all sounds like a recipe for a stronger dollar and a weaker stockmarket.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

So why is Wall Street still hitting record highs?

The market isn't always right in fact, it's always wrong

The Fed reckons it will "soon be appropriate" to raise rates again in June, in other words. It also thinks that the relatively weak growth seen in the first quarter of this year was "transitory", and that recent weak inflation is also "transitory".

In other words, it's sticking to the course of gradually raising interest rates and it's even thinking about ending quantitative easing altogether. (At the moment, when any of the bonds that it holds mature, the Fed reinvests the money in more bonds so the central bank never actually removes any money from the market.)

Looking at this stripped of context, it might seem odd that the dollar continued to weaken after the Fed's release. After all, the US is the only major developed world central bank that's raising interest rates. The Bank of Japan, the European Central Bank (ECB), and the Bank of England, are all in limbo, at best.

But the most important thing to understand about markets is that prices are not based on today's reality. They are based on what people expect to happen tomorrow. The assumptions behind those expectations range from sober-minded, well researched and rational, all the way through to poorly understood, sloppy and delusional. And no one can perfectly predict the future.

That's why markets can only ever reach an approximation of what's going on, and it's why, rather than always being right (as the efficient market hypothesis might have you believe), they are in fact, always wrong. Not necessarily by a lot but almost certainly by at least a little.

So how does this apply to what's going on today? At the end of last year, and the start of this one, everything looked rosy for the US, and extremely miserable for Europe.

The US economy was doing well. Donald Trump had been elected on a platform of getting stuff done, and in particular, cutting taxes and spending loads of money.

Europe, meanwhile, faced a critical election at a time when everyone was obsessing about shock' results. The fear was that Marine Le Pen would win in France, and she would take France out of the European Union, and the euro would collapse or fall apart.

So the obvious investment thesis was: buy the US dollar, sell Europe and the euro.

Yet both of those sets of expectations were heavily over-done. And if you'd stood back at the start of the year and thought about it, you'd have seen that quite easily.

Presidents never get things done quickly. That's the nature of politics. And it takes a good politician to get other politicians to do stuff at all. Trump's not a good politician. Hence the gridlock and the disappointment.

As for France Marine Le Pen never had a chance. Sure, lots of people said the same about Trump and Brexit. The big difference was that in those cases, the polls clearly showed that they did have a chance they weren't the favourites, but they were a possibility. The polls for Le Pen were never that close.

In short, the market was overly gloomy on Europe, and overly excited about the US.

Markets love a weak dollar

It doesn't matter that the Fed is raising rates. The market knew that already. What it's more interested in now is the fact that the eurozone economic data is improving and German chancellor Angela Merkel is getting ratty with the ECB for printing money. With the Germans up for election next, and the German voters not too keen on money printing, we can surely expect that rhetoric to pick up.

So the markets are adjusting. The dollar is too expensive. The euro is too cheap. The single currency has already jumped a fair bit indeed, as Bloomberg points out, "it's turning out to be the best year in a decade for the shared currency". Investment banks are raising their forecasts, and hedge funds are shifting their bets around.

The cycle will go on, of course. It won't take that long before there will be too much good news priced into Europe. But I don't think we're there yet. And I think the Fed will be happy to see the dollar weaken a little, frankly.

What does the weak dollar mean? A weaker dollar tends to be good news for both gold and industrial commodities, and for stocks in general. A weaker dollar essentially means looser monetary policy for the rest of the world.

It might make life trickier for the big dollar earners in the FTSE 100, but at the same time it also means the likes of retailers and other sectors that suffered from the weak pound will get a bit of a lift as it rallies.

In the longer run, a weaker dollar will make the Fed's job a little trickier. A weaker dollar should be inflationary. And with the US jobs market showing quite extraordinary strength, particularly in recent weeks (the number of claims for unemployment benefits is at near-30 year lows), the risk is that wage pressure will start to kick in at the same time.

By then, no doubt, the dollar will have been written off (again) and the euro will be in the ascendant (again), and expectations will have flipped so far that the market will be in for another uncomfortable period of adjustment.

But that's a story for another day. For now, it's weak dollar mode, which markets like.