Over the past couple of months, the “dollar liquidity/dollar shortage” story started to reclaim its place in the larger market narrative.
Despite a dovish Fed and falling real yields, the greenback has remained largely undeterred – resilient throughout, thanks to the concurrent dovish pivot from the FOMC’s global counterparts and the relative strength of the US economy.
This is a potential problem for risk assets. Until recently, everyone (or nearly everyone) has demonstrated a remarkable propensity to look the other way, but now that the trade war is back, some worry we could be in for a repeat of 2018.
“As a relatively closed economy – and one benefiting from tax reform policies –the US economy powered ahead [while] other, more open economies began to slow notably”, BofAML’s Barnaby Martin writes, recapping 2018 in a new note out Tuesday.
He continues, noting that “between April ’18 and September ’18, for instance, the Nasdaq rose 17%, while the MSCI Emerging Market equity index fell 11%”. The dollar rose by some 7% over that period.
As Martin reminds you, “a rising Dollar was the ‘canary’ for markets” last year, and there were “two negative consequences for European assets” (Martin is of course BofA’s European credit strategist, so his notes are written from that point of view).
For BofA’s European credit team, the avenues through which the dollar impacted European assets in 2018 are relevant today and investors would do well to be “mindful” of them.
First, Martin reminds you that demand for T-bills (i.e., USD “cash”) was a major factor in explaining diminished risk appetite last year. When the dollar is appreciating, the effect is amplified. “European retail investors began to buy US T-bills unhedged, as the US$ was rallying, [and] the allure of T-Bills is even greater for European investors at present”, he writes.
Second, BofA goes back over the nexus between emerging markets and European risk assets.
“EM volatility had a greater knock-on effect to European equity markets given European companies have increased their EM revenue exposure over the last decade”, Martin says, adding that “given the domestic nature of many S&P companies, US equities were not impacted to the same extent by EM weakness.” See the chart in the left pane below.
Meanwhile, European HY is sensitive to EM FX vol. This is a point Martin has made on several occasions previous, and as you might imagine, it’s still highly relevant given the renewed hunt for yield keeping € junk spreads disconnected from reality and the trade war raising the specter of dollar strength and EM FX turmoil.
“EM FX vol has crept higher this month [and] although it is still well below the August peak last year, our Emerging Market FX team highlight that positioning is currently heavy in EMFX, and they believe positions are at risk if the US Dollar moves higher”, Martin continues, referencing the chart in the right pane above.
When you throw a dash of Italian political turmoil into the mix, all of the above gets especially interesting… errr, spicy.
The bottom line is this:
Today, we again think that a rising US Dollar will be the “canary” for Euro corporate bond markets. Investors should keep a close eye on this.
Yes, investors should “keep a close eye” on the stubborn dollar – and not just European credit investors.