A broad consensus has emerged that the dollar needs to take an extended breather if ex-U.S. risk assets are going to have any hope of stabilizing.
There’s nothing particularly novel about that assessment. Persistent dollar strength in the face of Fed tightening is obviously EM negative and the fact that years of accommodative DM policy helped push investors down the quality ladder and out the risk curve means that when the hunt for yield slams into reverse, the unwind is likely to be more dramatic than it might have been otherwise. You’re seeing that play out in real-time across developing economy assets.
Where the discussion gets a bit more nuanced is when you take into account the fact that the very same policies which have pushed the dollar higher and piled pressure on emerging markets are also in large part responsible for the resilience of U.S. equities to turmoil in ex-U.S. assets. The tax cuts and late cycle fiscal stimulus more generally have led directly to record corporate profits, a buyback bonanza and ongoing strength in the U.S. economy, all drivers of U.S equity performance.
Meanwhile, U.S. trade policy also plays USD positive and EM negative. The threat that tariffs will dent global growth and exacerbate the deceleration in China’s economy is clearly a drag on sentiment in developing economies while the prospect that protectionism will drive up consumer prices stateside prompts the Fed to lean ever more hawkish, lending further support to the greenback as rate differentials move further in favor of the dollar.
At the same time, Italian political risk and the prospect that the European banking sector could see some spillover from Turkey continues to weigh on the euro. The policy divergence between the Fed and the ECB is also a factor and the UST-bund spread is still sitting at its widest in decades. Trade frictions between the Trump administration and the E.U. (especially over autos) have also been a headwind for sentiment in key sectors across the pond, leading to underperformance versus U.S. assets.
Now, though, the concern is that with U.S. stocks sitting at new highs, spillover from the malaise playing out overseas could come calling just as the effects of stimulus begin to wane, leading to a kind of Wile E. Coyote moment for the S&P and the Nasdaq.
JPMorgan’s Marko Kolanovic talked at length about this in his latest note out late last month. For Kolanovic, the “unprecedented” divergence between U.S. stocks and the rest of the word will resolve itself in one of two ways:
- ‘Risk on, USD down’ outcome with EM and value assets staging a rally and USD selling off, while US stocks continue going higher (but lagging).
- Alternatively, we could see a “Risk off, USD up” convergence, with US markets selling off and catching up with the poor performance of Europe and EM assets, e.g. driven by a continuation of the trade war and further USD strength (for now we will ignore a spectrum of ‘in-between’ outcomes).
It’s too early to know which of those scenarios will ultimately play out, but it’s worth noting that emerging market equities posted their best week since March after Kolanovic’s note was published, and that performance was largely down to Trump jawboning the dollar lower, an effort that was turbocharged by the PBoC’s decision to reinstate the counter-cyclical adjustment factor in the yuan fix.
So, whither the dollar? Or, maybe this: Will the dollar wither?
Some folks think the answer to that latter question is likely “yes”. For instance, in a note dated August 27, Deutsche Bank’s Alan Ruskin and George Saravelos talk extensively about all of the issues above in the context of a “multipolar” world “where the USD is in the main driven by US fundamentals, and its two main anti-poles, the EUR, and the CNY”.
Recently, Ruskin and Saravelos write, all of those drivers have skewed dollar positive. To wit, from the note:
In the US, a mix of strong data, and, Fed rate hikes that have conformed to the dots rather than dovish market expectations, have all been USD supportive. In China, the mix of trade tensions with the US, and the less well appreciated collapse in liquidity/money aggregates forcing policy easing, have placed the CNY under pressure. And in Europe, Italian politics has interjected itself, while the ECB has taken the unusual step of pre-signaling policy far in advance, both undermining the EUR.
For Deutsche Bank, at least two of these drivers will likely begin to skew dollar negative or, at the very least, not dollar positive, going forward.
With respect to the dollar’s “anti-poles”, Deutsche notes that eventually, the rate spreads pillar should become more supportive of the single currency despite the ECB starting from behind when it comes to normalizing policy:
At least until early 2019, s/t rate spreads if anything will move in favour of the USD. Thereafter, an ECB tracking close to three and a half years behind the Fed, should finally become a more compelling EUR positive factor. Market pricing of a first ECB rate hike for March 2020 is inconsistent with a the healthy domestic demand picture and a tightening labor market – it is notable that the Eurozone – US employment to population ratio gap is tighter now than pre-crisis . By mid-2019 orthodox Taylor Rules are likely to suggest that the current ECB target rate is 200+ bp below what it should be, leaving plenty of scope for ECB tightening to accelerate.
Of course Draghi went out of his way in June to introduce state-and-date dependent forward guidance which essentially ruled out a hike until late next year. That raises the specter of “quantitative failure” if the econ rolls over, but that’s another story. The risk, as Deutsche Bank makes clear, is that the Italian situation deteriorates anew prompting the central bank to lean even more dovish on rates. Barring that, the euro could firm.
The dollar’s other “anti-pole”, the yuan, is being driven by policy divergence with the Fed and the threat of a protracted trade war. We’ve obviously spent a ton of time talking about how the PBoC has effectively been able to sit on its hands and let the policy divergence and Trump’s shrill rhetoric do the work when it comes to pushing the currency weaker and offsetting the effects of the first two rounds of 301-investigation related tariffs. Starting earlier this month, Beijing began to lean against further yuan depreciation, a push that culminated in the above-mentioned reinstatement of the counter-cyclical adjustment factor.
Over the least three months, markets have been at pains to discern what the controlling factor is for the Chinese currency’s rapid depreciation. To be sure, everyone can make a list of the contributing factors (e.g., the policy divergence and the threat that trade tensions could further undermine the already decelerating economy thus necessitating easier monetary policy and still more divergence with the Fed), it’s just a matter of deciding which one takes precedence.
In their note, Deutsche Bank picks up on this. “Recent CNY weakness can be ascribed to two overlapping macro features: a looming trade war; and, US – China monetary policy divergence”, Ruskin and Saravelos write, adding that “both trade tensions and policy divergence are unlikely to provide a positive quick fix for the CNY.”
Why is there no “quick fix” in the cards? Well, for Deutsche Bank, the trade war is more than a trade war. Rather, it “represents a broader re-evaluation of the US – China strategic relationship”. That characterization suggests frictions will remain for the foreseeable future.
On the policy divergence, the bank notes that fiscal policy might be constrained in its ability to lend a helping hand (the Politburo would probably disagree). “The more monetary easing is attempted, instead of fiscal accommodation, the more this is CNY negative”, the bank says, adding that they see USDCNY “well above” 7 by year end.
So the read-through from the EUR and CNY discussion there is that the euro will eventually get some support against USD assuming Italy doesn’t implode, while the yuan is perhaps another story.
Coming full circle to the other driver of the dollar, U.S. fundamentals, it’s important to remember that it wasn’t so long ago when everyone was “sure” that the greenback would quickly succumb to worries about the U.S. fiscal path. In fact, through February, the dollar stubbornly refused to respond to a favorable shift in rate differentials. The idea that U.S. trade policy was a weak dollar policy by proxy only put more pressure on the greenback (Steve Mnuchin didn’t do anything to dispel that notion in Davos).
That all reversed in dramatic fashion starting in April and the rest, as they say, is history.
Seen in the context of the U.S. fiscal trajectory, the dollar’s recent gains are really just a reflection of the market assuming that between now and whenever reality comes calling, the Fed will be inclined to be near-term hawkish, supporting the currency. Eventually, though, the piper will need to be paid. Here’s Deutsche Bank again:
The fiscal stimulus will encourage faster US short-term rate normalization than the market expects, but by 2020, the fiscal accounts will be in their most precarious state for a long upswing since WW2, leaving all the burden of responsibility on the monetary policy to ease aggressively as growth slows. 2020 /21 Fed easing is apt to occur just as the negative public sector savings shock is becoming more apparent in the US external accounts. This is the worst of all worlds for the USD – a sharp reversal toward easing in rates, occurring as the larger external deficit poses a more evident funding problem.
There you go. At that point, we’ll get to ask this: Who will sponsor the U.S. long end against a “deplorable” fiscal backdrop and in the face of a Fed that’s cutting rates? Probably nobody, or at least not at yields that are anywhere near where they are currently.
Putting it all together, Ruskin and Saravelos say “the tailwinds that in recent months have propelled the USD to within striking distance of new cycle highs on the Fed’s broad USD trade-weighted index, are likely on the wane [and] this should temporarily prove helpful for risky assets, and EM currencies in the next few months”. That’s just a reiteration of everything said here at the outset.
As far as what could tip the scales in favor of more greenback strength, it’s the usual suspects: Faster rate hikes in the face of a sharp acceleration in inflation, a better than expected fiscal trajectory for the U.S. and/or an ECB that’s forced to delay normalization further.
When it comes to what could play more dollar negative and thereby add to what the bank expects will be a pullback from recent highs, we’ll simply leave you with Deutsche Bank’s list (and do note point number one) …
- US politics is potentially a multi-prong USD negative. The inter-related mid-term elections/the Mueller investigation/Administration verbal and actual FX intervention.
- USD long positioning is already extended, which is influential for the next few months.
- Reduced foreign liquidation of EUR Bonds, mirroring the local slowdown in EUR bond selling.
- Global risk sentiment improves.
- US twin deficits come back into focus.
- Accelerated ECB tightening.
- Undershooting US inflation, partly as a result of an already strong USD.