Canary Tipping And Dynamite Fishing

Well, the dollar’s retracement lower that saw the greenback post its first weekly loss in a month last week following the CPI miss continued on Monday and that was good news for Asian currencies, and for risk assets more generally.

DXY

The ringgit reversed a knee-jerk lower as local markets reopened following Mahathir Mohamad’s shock election win and after a wild ride, Malaysian equities closed slightly higher after recouping an opening plunge.

As we noted in our week ahead preview, this week is all about the dollar and whether the breather it took last week was a sign the rally has run its course or whether that was just a break on the way higher. The dollar short has been trimmed recently, but there’s no reason to believe that the Fed is going to be backing off anytime soon and when it comes to the recent turmoil in emerging markets, Jerome Powell didn’t sound too concerned last Tuesday in Zurich.

Mester was on the tape this morning. “I wouldn’t be surprised if we see the near-term inflation readings go higher,” she told Bloomberg TV, adding that the Fed “can stay on our gradual upward path of interest rates.”

“In my view, the medium-run outlook supports the continued gradual removal of policy accommodation; it seems the best strategy for balancing the risks to both of our policy goals and avoiding a build-up of financial stability risks,” prepared remarks for a speech speech in Paris from Mester read.

You get a sense that until something snaps (as it were), the dollar isn’t likely to face much in the way of resistance on the way higher.

Two people who think this is trouble (and have for a while) are Nedbank’s Neels Heyneke and Mehul Daya, who write the following in a new note appropriately entitled “Have The Canaries Started To Fall Over?”:

The dollar turned up from a very important support line (from the 1985-high), and the latest rally was very strong. The million dollar question is whether this will be a false start again. We do not believe that it is. There are many “canaries” that are starting to “fall over” – hence we are deeply concerned about current market conditions. We are faced with very large risk-on positions (ie record netlong positions in oil, copper, EUR/USD etc).

They go on to predict higher real rates, a drag on risk assets and a deflationary dynamic as tighter financial conditions take hold.

“We therefore expect the US10yr to rally (continuation of the 30yr bull trend), reflecting the deflationary forces of a stronger dollar and contraction in the Global $-Lliquidity – this would not bode well for risk-assets (like SA bonds/FX/equities),” they continue.

ACM

For the time being, oil has of course risen with the dollar (or the dollar has risen with oil, depending on how you want to look at it). This is a consequence of oil’s relationship with inflation expectations and the extent to which real yields have become a function of those expectations. We’ve been over this a thousand times if we’ve been over it once (see here, for instance).

If oil rolls over in an environment of rising real yields and a stronger dollar, well then you’ve got an even more acute loss of dollar liquidity. Here’s Nedbank again:

Our Global $-Liquidity indicator is losing momentum due to the tightening monetary conditions by the US Federal reserve (and as US current deficit shrinks). Oil is one of the largest contributors to Global $- Liquidity. If oil loses momentum, it reduces the number of petrodollars in the financial system, and adds to the $-Liquidity shortage. As dollar liquidity slows down, it is likely to unwind the extreme positioning and enforce a strong dollar (ie de-risking).

DollarLiquidity

And of course, the knock-on effect for EM would be dramatic. Here’s what we said over the weekend, commenting on Powell’s comments on EM’s preparedness (or lack thereof):

For those who missed it, here’s what Powell said at an IMF/SNB event on Tuesday:

Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.

Clearly, all of that is debatable. While there may indeed be “good reason to believe” that DM policy normalization will ultimately be digestible for developing economies, there’s also “good reason to believe” that the global hunt for yield catalyzed by DM central banks’ foray into ZIRP, NIRP and QE contributed mightily to investors’ appetite for emerging market assets. In fact, there are plenty of folks who would argue that the proximate cause for inflows into EM was DM easing and to say otherwise is to be deliberately obtuse. Powell hedges a bit by including the word “relatively”, but the comments excerpted above will undoubtedly be trotted out later as evidence of negligence in the event we do see an EM unwind.

Well, in the same vein, Nedbank says the following:

The Bloomberg Barclays EM local and USD denominated debt spreads has taken out the highs of 2016 and has broken into the late-2016 lows. This is likely to be more than just a correction phase and should target the neckline at 5.50%. The world, and in particular emerging markets, has been on a dollar debt binge – one that has issued over $3.5.tn (rest of world $10tn) in dollar debt. Hence our concern that a slowdown in dollar liquidity would not bode well for dollar-indebted nations/corporations. If EM currencies fail over the next few days to break back into the bull trend that has been in place since the start of 2016, then it is just a matter of time in our opinion before the EM currencies force foreign investors out of the EM markets.

EMDebtCost

There you go. Canary tipping and dynamite fishing.

Draw your own conclusions and we would note that there’s a counterargument here. There are dollar negative structural factors that could reassert themselves over time as the U.S.’s “deplorable” (pardon the pun) fiscal condition and the weak dollar policy by proxy embedded in Trump’s trade stance once again dawn on the market.

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