Headed into 2020, the combination of the Sino-US trade truce and a dovish Fed set the stage for the dollar to extend declines logged in the fourth quarter, providing a fillip to the reflation trade and bolstering global growth in the process.
Or at least that was the thinking for some market participants. But you know what they say about the best-laid plans.
The narrative made sense. The “Phase One” trade deal and dozens of rate cuts from central banks around the world ostensibly laid the groundwork for the global economy to play catch-up to Donald Trump’s MAGA machine. As the economic performance gap between the US and the rest of the world closed, one pillar of dollar strength would crack. Meanwhile, the Fed all but promised to persist in messaging that suggested the bar for rate hikes is impossibly high, while the bar for additional cuts is fairly low.
Fast forward nearly two months into 2020 and the greenback is on pace for its best start to a calendar year in half a decade.
There’s no mystery here. The coronavirus outbreak suggested the global economy was on the verge of succumbing to an “out of the frying pan and into the fire” dynamic. No sooner had the trade war abated than a new threat to growth and commerce emerged. Because it seems highly likely that the economic fallout from the virus will disproportionately affect ex-US economies, the assumption now is that US economic outperformance will continue, leaving one of the key pillars of dollar strength intact.
Meanwhile, the necessity of policy easing in other locales to offset the assumed deleterious effects of the virus means the monetary policy divergence between the US and its global counterparts could widen anew, even if the Fed continues to deliver dovish forward guidance.
For evidence of that, look not further than the euro, which is sitting near the lowest levels in years after a string of disappointing data suggested the bloc’s economy was stumbling even before the epidemic began to spread across China. The euro-area economy barely expanded in Q4, data out late last month showed. Growth decelerated to a minuscule 0.1% pace QoQ, less than the 0.2% the market was looking for, marking the worst quarter in nearly seven years. France and Italy unexpectedly contracted.
In Germany, the situation is dire indeed. “For the euro-area in particular, the virus shock may extend the streak of weaker-than-expected activity data, raising questions about whether a durable recovery has actually taken hold”, Goldman’s Zach Pandl said Thursday.
“Apart from benefiting from its status of a safe haven, the dollar is also supported by the ongoing expansion of the US economy”, Rabobank’s Piotr Matys wrote this week, adding that recent data has seemingly “confirmed that the US continues to outpace its G10 peers in terms of economic activity [and] it’s worth noting the Bloomberg Dollar Index broke above the downside trendline that capped gains since October [a] constructive technical signal may embolden the USD bulls”.
This dynamic is at the heart of some arguments for why the Fed will ultimately be forced to keep easing, perhaps until they hit the lower bound. If they don’t, a stubbornly strong greenback will simply import the world’s disinflationary impulse at a time when a trio of Fed cuts has already failed to reinvigorate inflation expectations.
Haven demand for USD assets amid the Wuhan outbreak only exacerbates the situation.
This is bad news for global growth, folks. As discussed at length here on Wednesday, the current setup is conducive to catalyzing bull flattening in the US curve, which only amplifies the disinflationary signal to markets.
Previously, any negative correlation between the dollar and the curve was due primarily to bear flattening and bull steepening, as a stronger economy raised the odds of tighter Fed policy (stronger dollar) and vice versa (weaker dollar as short rates fall in anticipation of easier policy). Now, that mode has changed. As Deutsche Bank wrote this week, the interaction between the dollar and the curve slope is now “a result of persistent dollar strength and its dampening effect on inflation expectations”.
For their part, Goldman suggests the impact on global growth from the virus will be “10 times as large as a major US hurricane”, and when it comes to the disruptions to work in China, the fallout from the epidemic is set to approximate “the entire US workforce taking an unplanned break for two months”.
A stronger dollar will be both a symptom and an aggravating factor in all of this, creating a non-virtuous loop, something Invesco Asset Management’s Arnab Das reiterated at a conference in Miami recently. “When the Fed shifted gears to easing and cutting rates, all it really did was open the door for everybody else to either cut rates or increase the size of balance sheets, or both”, he remarked. “So the interest-rate differential, monetary-policy differential, balance-sheet differential arguments in favor of a weaker dollar haven’t worked either. Those issues are still going to be there for some time to come”.
This is a great time to recall something SocGen’s Kit Juckes said back in December, before anyone was worried about a pandemic: “The world’s a nicer place when the dollar’s on the back foot”.