The US dollar has every reason to keep rising – there’s just one problem

Welcome back – I hope you had a great Christmas and New Year.

Last year, oil and China were two of the biggest stories in the markets.

And as 2016 begins, that doesn’t look like changing…

China slides, oil bounces

The year is starting with a bang.

China’s stockmarket has suffered its worst start to a year on record. Trading was halted after the CSI 300 index of large caps fell by 7%. The slide came after activity in China’s manufacturing sector shrunk for the fifth month in a row. Investors are also concerned about a ban on short selling coming to an end imminently.

The Chinese central bank (the People’s Bank of China) rattled everyone even more by setting the “daily fix” on the Chinese currency to be weaker against the dollar than at any point in the last four years.

So that big story – China’s weaker growth, potential devaluation and the impact on the rest of the world – is still rumbling along.

Meanwhile, after a horrendous 2015, the oil price bounced higher this morning. It’s all down to that old chestnut, “tension in the Middle East”.

There’s always tension in the Middle East. It’s not a region known for its tranquillity. But there’s more turmoil than usual. The simmering cold war between Saudi Arabia and Iran is getting hotter by the minute, with the Saudis now severing diplomatic relations with Iran.

As the BBC puts it, the pair are the major Sunni (Saudi) and Shia (Iran) powers in the region, and they’re each “backing opposing sides in the conflicts in Syria and Yemen”.

And if there is one thing that could quite possibly give the oil price a boost this year, despite the supply glut and all the rest of it, then I’m guessing that it’s a full-blown war between the two oil powers.

The biggest story of all: the strong US dollar

These two big stories have one even bigger story in common, of course – the strong US dollar. China is wilting under the strain of having the yuan, its currency, loosely tied to one of the strongest currencies in the world right now. That’s not much fun for an economy where exports are still important, and which wants to be making monetary policy looser rather than tighter. Hence the efforts to allow the yuan to weaken.

Dollar strength has also played a key role in the weakness of commodity prices, particularly over the last 18 months or so. That in turn has helped to increase tensions in the Middle East. It’s far from being the only factor, of course. But it’s in the mix all the same.

There is every reason for the US dollar to keep getting stronger. The US economy looks healthier than many others. The banking sector is relatively healthy too. And the Fed is planning to raise rates at least four times this year – more than any other major central bank.

All good reasons why “long dollar” is such a popular bet right now. But as I’ve said before, that popularity is what makes me question it.

What could derail the US dollar bull market? Well, it’s just worth remembering that the worse things get, the trickier it’ll be for the Federal Reserve to stick to its current game plan. Remember that just a few short months ago, tremors in the Chinese stockmarket swayed the US Federal Reserve not to raise interest rates.

We’ll see what happens. But the last thing the Fed wants is a huge devaluation by China to rattle the markets. I strongly suspect that both the Fed and the People’s Bank of China would rather see an “orderly re-adjustment” of the yuan, which is central bank-ese for “we’d like to see a slightly weaker yuan, but not too quickly”.

One way to provide the breathing space for such a move is for the Fed to disappoint the market and take the wind out of the dollar’s sails. It might not be able to stop the bull, but it can slow it down long enough to allow the yuan to weaken gradually and at a pace that won’t panic the markets too much.

My point is that you shouldn’t bet the house on the dollar bull market continuing this year. There’s a lot of potential for disappointment there, and a lot of powerful people who wouldn’t be sad to see at least some of the steam come out of its strong run.

In the next issue of MoneyWeek magazine, out on Friday, we have our experts’ big predictions for 2016. Don’t miss it.

And if you’ve made any New Year’s resolutions to sort your finances out – well, we’re ready to help you with that. Subscribe now for a great deal – check it out here.