Strong dollar poses risks for reluctant policymakers
August 4th, 2019
The Fed cut rates by 25 basis points (one-quarter of a point) last week, as expected, amid signs of slowing global growth. Chairman Jerome Powell tried to reassure investors that the economy was still on solid ground and that the move was merely a “mid-cycle adjustment”, not the beginning of a prolonged easing cycle. Don’t bet on it. Persistent strength in the US dollar is both a sign and a reason why a recession is closer than they think.
As we’ve noted repeatedly here before, the US dollar is the Achilles heel of the international financial system. Through their easy-money policies in the wake of the 2008 recession, the Fed encouraged a massive buildup in leverage by both sovereign and corporate entities. Unfortunately, to service that debt borrowers are negatively exposed to any decrease in the supply or increase in the price of those dollars.
In the past year, slower global growth, declining international trade volumes, tighter US monetary policy and a reduction in the Fed’s balance sheet have all contributed to a reduction of dollar liquidity in funding markets. This fundamental shortage of dollars has driven its price higher on FX exchanges. In 2018 a strong dollar roiled the markets (especially emerging markets) before the Fed was forced to pull the plug on its monetary policy normalization plans in the hopes of capping the currency’s rise. It worked, barely. After pausing for a couple of quarters the dollar is on the move again as the global shortage intensifies. See https://bloom.bg/2YnU5fh. The path of least resistance is clearly higher, perhaps significantly, and it’s going to take a lot more than one rate cut to turn it around.
Compounding the dollar squeeze is the current budget bill crafted by congress, which eliminates the debt ceiling for the next two years and allows US government spending to increase virtually unchecked. To meet these new financing needs it is expected that over the next several months the treasury will need to raise $250 billion in fresh cash, further draining the supply of dollars in the system. See https://on.wsj.com/2SXVJOE.
Despite the shift toward easier monetary policy, the broad dollar index (DXY) climbed to its best level in two years. The FX market’s message to the Fed is unmistakable: the cut in rates was too little, too late. The risk for policymakers from here is that a stronger dollar will create deflationary headwinds, possibly tipping weak economies into recession, and force the Fed to cut rates deeper than they’re willing to admit.
Canadian dollar vulnerable to drop in energy prices
July, 21, 2019
Energy is by far Canada’s largest export and production accounts for close to 10% of the country’s annual GDP. Subsequently, the Canadian dollar, colloquially known as the Loonie after the bird featured on the back of the dollar coin, is heavily influenced by the state of play in that sector and rarely strays too far from the prevailing trend in commodities prices, especially oil.
So far in 2019, the CAD has ridden a rising tide in stocks and commodities as the major central banks, led by the Fed, try to reflate the markets and breathe life into an aging economic cycle.
The promise of plentiful liquidity has been generally successful in driving financial markets higher, but we have doubts that this strategy will produce a meaningful boost to actual growth. One reason for that skepticism is derived from the distinct underperformance of the commodities complex this year (see chart below.) As a macroeconomic benchmark, commodities appear to be far less optimistic on the future than the message coming from the stock market. Like any divergence between normally-correlated markets, it could mean nothing or it could be an important message. Time will tell.
Oil, in particular, has had a very bad week when perhaps it shouldn’t have, given the tension with Iran in the Strait of Hormuz where 20% of the world’s petroleum supply passes. See https://bit.ly/2Y5BJyI. Prices in the futures market are down more than 9% and the energy sector as a whole looks vulnerable to further pressure. It’s tempting to sell commodity-sensitive currencies on the bet that they will follow suit.
Shorting the Canadian dollar represents an attractive risk/reward proposition. Not only is it still within 0.5% of its highs on the year (vs USD) but unlike most of its peer group of commodity currencies the speculative community is long and leaning the other way.
Calling turns in any market is tricky. We like owning USD/CAD here as long as it holds 1.3000, a risk of less than 1%. We think it’s a good trade but if we are wrong it won’t cost a lot to find out.
Coal miners used to carry caged canaries down into the mines on the theory that any presence of dangerous gases would kill the birds before the humans and serve as a warning for workers to exit the tunnels.
Over the years the term has evolved as a metaphor for early signs of trouble in the financial markets.
The Australian dollar (AUD)/Japanese yen(JPY) FX pair is probably the best-known benchmark of risk sentiment, with a well-deserved reputation as a leading directional indicator for markets in general.
On one side is the Aussie dollar, a liquid high-beta currency that is reflective of prevailing global macroeconomic trends, and on the other is the yen, best known as a reliable safe harbor destination in uncertain times. If that pair is rising (AUD outperforming the yen,) it most likely means economies are expanding, markets are happy and the outlook for asset prices favorable. If it’s falling (JPY outperforming,) the opposite. Simply, AUD/JPY is the ultimate canary in the Wall St. coal mine.
International trade and supply chain disruptions have taken a big bite out of global growth. Despite the slowing economy, expectations of even more central bank stimulus have kept financial asset prices elevated. But that fundamental divergence can’t go on forever. The Fed has some room to cut rates but in most other countries yields are already at historic lows while world-wide debt stands at record highs. Investors appear to be slowly coming to the conclusion that more of the same policies aren’t the answer. Either growth needs to accelerate or there has to be a reset lower in the financial markets. The breakdown underway in AUD/JPY is a sign that the canary is keeling over and that the latter outcome may be unfolding.
Amid the back-and-forth of retaliatory trade tariffs between the U.S. and China are some important tells in price action that indicate the situation has moved beyond bluster and snark into a more protracted standoff with negative implications for global growth. Any inclination to think that this too will soon blow over, like previous disputes in the negotiating process, should be checked against the breakdown in commodity prices and treasury bond yields as well as macroeconomic risk benchmarks like the Australian dollar and the Chinese yuan. We warned about this possibility one month ago in What’s wrong with this picture. Both currencies are now perched on a cliff edge (see chart below.) As a proxy for the general global condition, the Aussie dollar’s plight is particularly concerning.
China and the U.S. appear squaring off for a harder fight. Trump clearly sees toughness on trade to be a winning issue for his 2020 election campaign. With an increasingly dovish Fed as his insurance policy against harm to the economy or equity markets, previous assumptions that the president had been bluffing a weak hand or was too eager to cut a deal with the Chinese are proving wrong.
Trump’s aggressive posture is backing Chinese leadership into a corner. One reason blamed for the collapse in talks late last week was China’s demand that the text of any agreement is “balanced,” reflecting respect for its sovereign “dignity.” (https://reut.rs/2JgYqZF ) Those are loaded terms that mean different things to different people. But the need for saving face in many cultures can’t be overstated and the insertion of feelings into the equation now makes any potential deal significantly more difficult to achieve. Investors are right to worry that this sharp-elbows approach on trade by the U.S. will also draw similar reactions when it comes time to negotiate with the Japanese or the Europeans.
Markets are on the edge of a paradigm shift. The FX, commodity, and bond sectors have been telling us for some time that the threat to global growth from disruptions in supply chains and to fixed investments due to changing terms on trade are more pervasive and may be longer lasting than many forecasts currently assume. Volatility is waking up as doubts emerge over central bankers’ ability to counter these headwinds with traditional monetary policy. It’s a massive red flag and a sign that risk may be underpriced. Despite that, the temptation to buy weakness in this ten-year-old equity bull market is both instinctive and strong. But if FX (especially AUD and/or CNH) starts to break lower from here, this time will almost certainly be different.
Economists are having a tough time figuring out why the market is pricing in potential rate cuts in the US while the economic data is so good. It’s a good question. GDP growth is above trend and the country is considered to be at full employment. Assuming all markets are equally forward-looking, it’s hard to reconcile the growing gloom in the rate complex against generally positive news flow on the economy and with equities posting record highs.
As of now, the front-end rate futures markets are discounting one rate cut for this year and one more in 2020. This implies a sense of trouble appearing on the horizon that could require a policy response. The Fed says that rate cuts are not in play but they’re not trying too hard to dissuade investors from arriving at that conclusion.
Part of the concern can be attributed simply to the age of the current economic expansion. These things don’t last forever. Absent a total collapse, by July this expansion will become the oldest on record at 121 months. That would be more than twice the average of 59 months for the prior 13 cycles.
Another explanation is the lack of inflationary pressure now playing a larger role in overall policy calculus. Something has gone wrong when trillions in stimulus don’t buy a sustainable inflation rate.
But a more interesting theory for the move in rates involves the growing probability of a much stronger US dollar, an outcome that could ultimately force the Fed to hold back its rise with looser monetary policy. Deep liquidity and a robust US economy make the dollar the most attractive currency on the world stage, but it is a double-edged sword.
It remains my opinion that a higher dollar poses an unknown and very underappreciated risk for the global macroeconomic condition, and not just as a general deflationary headwind. The leveraged exposure to the dollar created by years of borrowing against easy Fed policy by both sovereign and corporate entities is massive. And like other extremes caused by excessively profligate central bank policies, it’s truly unprecedented. We really don’t know what these actions have wrought and what the impact will be when the unintended consequences are eventually revealed. 2018 gave us a small taste of what happens when the dollar goes up: emerging markets and other vulnerable dollar-sensitive credits fall first, and then like dominoes end up knocking over the developed markets. It could happen again.
For now, the conundrum continues. As we have been witnessing since December (and for the past decade), the equity sector thrives on even the slightest prospect for easier Fed policy. The reasons why never seem to matter. Until they do. If I’m right about the dollar, signs of economic weakness and lower rates should not be taken as a benign development but rather as a warning.