I certainly hope the prevailing narrative is clear to folks by now, but when it comes to “connecting the dots”, people aren’t generally very adept at doing a good Pee-wee impression, so I’d be willing to be not everyone has pieced the story together yet.
I’ve tried to flesh it out for you in a series of lengthy posts this week including the aptly entitled “‘It All Makes Sense When You Look At It Right’: The Dollar, Yields, Oil And The EM Bloodbath.”
I’m going to quote myself from another post in the interest of saving myself some time. To wit:
It’s a two-track story involving, on one hand…
- the evolution of inflation expectations and the interplay between late-cycle fiscal stimulus and the Fed’s propensity to tighten
And on the other hand…
- policy divergence between the U.S. and the rest of the world, the burgeoning U.S.-centric growth story and what that means for rate differentials.
The recently resurgent dollar has seen its correlation with 10Y yields and rate differentials restored. That means that as yields rise in the U.S. and as rate diffs move in favor of the greenback, the dollar rises in tandem. The Fed is staring down the prospect of fiscal stimulus being piled atop an economy running at or near full employment, a setup which means Jerome Powell needs to be acutely aware of nascent signs of price pressures. In this setup, real yields become, to a certain extent, a function of inflation expectations – the higher the perceived risk of inflation materializing, the more inclined the market believes the Fed will be to hike aggressively. Those hikes (or expectations thereof) push up real yields and in turn, the dollar.
It’s against that backdrop that the surge in crude is playing out and the dynamics described above are what make it possible for the dollar and oil to rise in tandem.
Here’s what one analyst I spoke to on Wednesday said, assessing my take:
That’s the fully closed loop version of the argument. I’d just make sure to underscore that it’s a two-track story based on real activity to disentangle: oil and USD can go up together because this is a supply side move and the delta on relative global growth is shifting back to the US over EU/EM.
Well, persistent dollar strength, rising U.S. yields and expectations of a more aggressive Fed have piled pressure on emerging markets. The problems you’ve seen recently in Argentina, Turkey and Indonesia simply represent what happens when idiosyncratic, country-specific problems and inherently precarious EM dynamics collide with, and are laid bare by, the external pressure from the stronger dollar and a Fed that’s predisposed to hiking.
Depending on what Mahathir Mohamad says between now and Monday (when local markets reopen), you could see something similar in Malaysia although he seems predisposed to heading off anything too dramatic (more on the Malaysia ETF and the move in ringgit NDFs here).
Ok, so in case the message has somehow been lost in my rambling, annoyingly lengthy missives, BofAML’s Michael Hartnett has condensed this into a nice, simple formula for you in his latest weekly “Flow Show” note. To wit:
EM cracks: 3% UST yields + $70/bbl. oil + rising US dollar = tighter global financial conditions = deleveraging in high beta, high leverage, low liquidity assets…largest outflows ($3.7bn) from EM equities & EM debt since Dec’16.
Hartnett goes on to reiterate what he said earlier this month regarding the real which, you’re reminded, seems to have overshot on broader concerns about EM rather than country-specific issues, given that electoral jitters don’t appear to justify the plunge.
Here’s what Hartnett said last week:
EM FX never lies and a plunge in Brazilian real toward 4 versus US dollar is likely to cause deleveraging and contagion across credit portfolios.
He reiterates that this week, noting that “BRL remains the key EM risk-metric [and the] closer to 4 it gets, the more EM deleveraging and potential for global contagion.”
As for his “Bull & Bear” indicator (that would be the one that flagged a sell signal the week before things fell apart earlier this year, taking its track record to a perfect 12/12), the good news is that the outflows from EM and HY have put it back to the lowest since January of 2017:
This, Hartnett says, is indicative of a shift in the regime “from buy the dip to sell the rip.”
Oh, and for fun, he includes a chart of the beleaguered rial which is in a race with the bolÃvar to see which currency will take the title in 2018 when it comes to “world’s biggest piece of shit”.
