Recently, the dollar’s positive correlation with 10Y yields has been restored. Here’s the 21-session correlation between the Bloomberg dollar index and nominal 10Y yields and reals:
The resurgent greenback is coming off its best month since the election on the back of Fed expectations, rising short-end rates, and the restoration of the above-mentioned correlation with long-end yields.
What’s the outlook? Well, that’s hard to say, because while one would be tempted to suggest that favorable rate differentials and policy divergence (hawkish Fed versus cautious ECB and dovish BoJ) should continue to support the previously beleaguered greenback, the Trump administration has adopted a weak dollar policy by proxy and America’s worsening fiscal stance paints a rather dour longer-term picture.
One thing we know for sure: a sustained bounce in the dollar will have ramifications for all manner of crowded trades because as Nomura’s Charlie McElligott recently put it:
Nearly every consensual macro trade has an implicit short-dollar view built-into it. A dollar squeeze is a major risk to longs including emerging markets, crude oil, the Nasdaq, the euro, the yen and industrial metals.
As far as the return of the correlation with rates (mentioned here at the outset) is concerned, BofAML is out with a new piece that documents this development and posits some implications in the context of EURUSD.
“Until a week ago, yield differential between the Eurozone and the US had moved in favor of the USD in 13 out of 20 weeks and yet it seemed to have barely registered with the beleaguered USD,” the bank writes, adding that “the 10-week rolling returns correlation between EUR/USD and 10y rate differential fell from +80% in the beginning of November to -20% by the first week of April”.
As you can see over there on the far right-hand side in the right pane, the 10-week rolling returns correlation between EURUSD and rate diffs rebounded to turn positive last week and as BofAML goes on to note, “over the last 10 trading days, 10y rate differential between the Eurozone and the US moved in favor of the USD for 7 days and on 6 of these days the USD actually went up against the EUR.”
If the dollar-rate differential correlation is back for good (“back in black”, as it were), BofAML reminds you that it “will have profound implications for everything the USD touches, whether it is the global rates market, emerging market, commodity market, or even the stock market.”
There’s a fairly lengthy discussion that follows the observations made above, but some of the key points end up finding their way into the bank’s list of “8 reasons for selling EURUSD now”.
Again, these are EURUSD specific, but the rationales end up touching on all manner of issues from the viability of the synchronous global growth meme (one pillar of “Goldilocks”), to trade, to the implications of tax reform in the U.S., to the discounting of America’s deteriorating fiscal position, to the curve, to the prospect that China will ultimately be unable to match Fed hikes with token OMO hikes leading to a narrowing of rate differentials and capital outflows.
Let’s take those in turn, excerpting BofAML’s analysis and visuals (in block quotes).
Viability of the synchronous global growth meme
#1: EUR strength is starting to hurt The fact that German and French PMI continued to be weak in April has helped discredit the view that the Eurozone slowdown since the start of the year was weather related and therefore temporary. So what is driving the Eurozone slowdown? In our view, any explanation needs to be able to account for two striking facts: (1) the Eurozone’s new manufacturing export orders have declined sharply even though those for the US have risen; (2) although Japan also saw an equally sharp drop in new export orders, the decline in its overall manufacturing orders have not been as severe as for the Eurozone (Chart 9).
#2 US growth to accelerate in Q2 US household spending grew only 1% in Q1, notwithstanding the 3.4% increase in real disposable income. Even if we were to assume that households plan to save a portion of the tax cuts they are receiving, it seems reasonable to think that private consumption is set to jump in Q2, especially given continued buoyant household confidence. More impressive is the fact that private fixed investment growth in equipment continues to trend up (Chart 11). Higher rate of business investment should help raise labor productivity and wages, and mitigate concerns about secular stagnation. With lower corporate tax rate, more favorable capital expenditure depreciation allowance, and strong corporate balance sheet (Chart 12), there are good reasons to think that this positive investment story is here to stay. This is why we think the widening of the USEurozone rate differential (reflecting higher terminal Fed Funds) is set to continue.
#3: NAFTA deal will ease USD’s political risk premium We recently argued that the elevated trade war risk premium cannot be justified by a careful analysis of the facts on the table. Since then, trade war fears have abated and we think there is room for the trade war risk premium in the USD to fall further. The catalyst could be a deal on NAFTA. We believe there is a good chance that the US will reach agreement with Canada and Mexico on a revamped NAFTA over the next few weeks. If we are right, this will help show the pragmatic side of the Trump administration’s pursuit of more favorable trade deals. A NAFTA deal will also increase the leverage of the US in its trade negotiation with China. A NAFTA deal might even change the US calculations for joining TPP. Trade deals that improve the competitive positions of US companies should be seen as very bullish for the USD long-term.
Implications of tax reform in the U.S.
#4: Corporate repatriations are set to pick up We continue to believe that corporate repatriations as the result of US tax reform will provide significant support for the USD in 2018. Even though unlike in 2005 US companies this time around do not face a deadline for bringing their offshore money home, a company that has decided to repatriate would have a very strong incentive to lock in the exchange rates right away. We think the Q1corporate earning season, which is set to continue in May, could provide US corporations with a window of opportunity to hedge their future repatriations.
China will ultimately be unable to match Fed hikes with token OMO hikes
#5: Risk of resumed capital outflows from China increases Capital outflows from China and reserve loss by the PBOC were a key if not the principal driver of general USD appreciation in 2015. Given the sensitivity of Chinese capital flows to interest rate differential between China and the ROW (Chart 13), rate hikes by the PBOC last year may have been intended to match the Fed hikes with the objective of limiting renewed capital outflows and RMB depreciation. However, given the continued deleveraging that is showing no signs of relenting (Chart 14), it does not seem likely that the PBOC will be able to match further Fed hikes. The key lesson from 2015 is that capital outflows from China could trigger capital outflows from the rest of EM. We view the increased risk of a repeat of 2015 as a positive for the USD.
Discounting of the deteriorating fiscal position in the U.S.
#6: Risk premium for fiscal deficit is already very high We share the general concern about the US fiscal deficit which will be over $1trn this year. Large fiscal deficit is a problem for the USD long-term since its reserve currency status is implicitly predicated on the assumption that Uncle Sam will always be able to pay its bills. That said, we would point out that the fiscal risk premium in the USD is already very high. Indeed, the 10y forward outright of EUR/USD is trading at levels that were associated with extreme pessimism towards the US in the past (Chart 15). In our view, the market is too concerned about the fiscal implications of tax reform and has not given enough benefit of doubt to the possibility that tax reform will raise long-term growth potential. This is why the USD will do well on positive growth surprises in the months and years ahead.
#7: Relative shapes of yield curves will support the USD The flattening of the US yield curve and the steepening of the Eurozone yield curve are bullish for the USD and bearish for the EUR. To understand this, compare a currency hedged versus a currency-unhedged investment in US and German bonds for Japanese investors. As Chart 16 shows, a currency-hedged investment in US bonds will take away any yield advantage of investing outside Japan whereas a currency-hedged investment in Bunds still offer a significant yield pickup versus JGBs. All else being equal, the fact that foreign investment in US bonds are more likely to be currency unhedged than for Eurozone bonds is bearish for EUR/USD.
#8: Loss of momentum makes EUR longs vulnerable Despite the recent loss of momentum of the EUR/USD rally, speculators continue to sit on massive EUR longs (at least in futures). History tells us that such divergence between momentum and positioning is not sustainable (Chart 17), especially given the negative carry associated with the trade. Capitulation by EUR bulls would certainly feed a meaningful USD rally.
Now if only Steve Mnuchin knew whether this is all a good or a bad thing. After all, a weaker dollar “is good for trade“, but on the other hand, nobody wants to say that too explicitly (especially after ol’ Steve “went there” in Davos, to much tomato throwing).
One thing’s for sure: if you’re in a consensus trade that is explicitly or implicitly short USD (and I guess that’s pretty much all of you), it might be time to reflect on the relative merits of holding those positions.
Oh, and on cue, just minutes ago:
- EUR/USD BELOW 200-DMA FOR FIRST TIME SINCE APRIL 2017