‘It All Makes Sense When You Look At It Right’: The Dollar, Yields, Oil And The EM Bloodbath

Folks seem to be having something of a difficult time reconciling what the likely fallout for markets will be from Trump’s decision to exit the Iran deal.

Although this is ostensibly bullish for crude (WTI breached $71 on Wednesday), the dollar continued its seemingly inexorable ascent into the announcement, helped along by its renewed correlation with 10Y yields, which topped 3% again today.

Here’s what Oanda’s Stephen Innes said on Wednesday:

The stronger U.S. dollar, which is running like a wrecking ball through global capital markets, is one of the more significant issues.

Right. And it seems to me as though higher crude prices are just as likely to beget a stronger dollar this time around than not. Nothing is certain here, but as long as inflation expectations and crude are tracking each other in lockstep…

(BBG)

…and as long as the reinvigorated correlation between the dollar and nominal 10Y yields holds…

(BBG)

…and as long as the market continues to believe that the Fed is worried about inflation in light of the presumed effect of piling fiscal stimulus atop an economy operating at or near full employment, well then the dollar can rise with crude as Fed hikes support real yields. Here’s a 21-session correlation between reals and breakevens:

(BBG)

Another critical point here is that the very same fiscal stimulus which should, one would think, eventually translate into sustainable signs of wage inflation stateside, is also expected to deliver a jolt to the U.S. economy, thus allowing an expansion that’s already the second-longest in recorded history to continue.

That, against a backdrop of seemingly decelerating growth across the pond, worries about what a trade war will mean for global growth more generally and the prospect of a weaker credit impulse in China tipping dominoes for the EM growth story.

Well, as noted last week, the dollar’s correlation with rate differentials has been restored as well and if we truly are transitioning to a U.S.-centric growth story, well then that’s going to push rate diffs even more in favor of the greenback and that reinvigorated correlation means that push will actually translate into dollar strength as opposed to instances where the link broke down last year.

As one analyst I spoke to this morning put it, “oil and USD can go up together because this is a supply side-ish move and the delta on relative global growth is shifting back to the US over EU/EM.”

That echoes (precisely in fact), what Deutsche Bank said last month:

We would expect that oil heading to near $80/b will be associated with a stronger USD against most currencies. This partly relates to the impact at the back-end of the curve, most obviously if the US 10y yield breaks 3.05%. At least as important will be the expected Central Bank policy response. As we have seen in recent days, a few tentative signs of slowing in the global economy will scale back expectations of tightening in most places, while having less impact on the Federal Reserve. The market is taking on board a view that the US will have a large fiscal inspired demand side shock that will more than offset any negative oil supply side shock, unlike much of the rest of the world, and the demand and supply side will provide a double whammy for US inflation pressures.

So there’s a certain extent to which this is a kind of two-track narrative but, to quote The Usual Suspects, “it all makes sense when you look at it right.”

As far as what this means for emerging markets, well it seems like they’re just fucked because the dollar strength and rising U.S. yields are going to, as the above-mentioned Stephen Innes puts it, “run like a wrecking ball” through developing nation currencies…

Hard to focus on Iran when the USD is running like a wrecking ball through global capital markets https://t.co/heU4Fn8VVy via @markets pic.twitter.com/k3BAVAtpW3

— Paul Dobson (@paul_dobson) May 9, 2018

And bonds (left-hand column)…

https://twitter.com/DavidInglesTV/status/994106876169109504

Again, “you gotta like, stand back from it, you know”…