Posts tagged dollar
(FX) Volatility to Make a Comeback?

I said my peace on what I consider to be the big market stories last week, so I won’t belabour bonds and equities too much this week. FX markets, however, could well be the driver of the NarrativeTM in the next few months, at least judging by the rustling of the grapevine. This story starts with the notion of the “global Fed,” which is not a new idea at all. Fed watchers tend to pivot between two extremes in their analysis of, and forecasts, for U.S. monetary policy. In one end, Fed conducts itself according to the reality of a relatively closed U.S. economy, without regard to the impact of its policy on the rest of the world, and the value of the dollar. At the other end, the Fed acts according to its role as a warden of the global reserve currency, taking into account the impact of its policy on the rest of the world. A more cynical version of this story is the idea that the Fed, in a world of free capital mobility, is constrained by the fact that other major central banks, in economies with large external surpluses, are stuck at the zero bound. This could happen in practice as tighter monetary policy in the U.S. drives the value of the dollar higher and/or leads to an increase in capital inflows. Both likely would drive up the external deficit, which would probably be counterproductive in an environment when the Fed would otherwise want to raise rates to curb inflation pressures.

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The Grand Finale

Let me run a story by you. The dollar is rising against both its EM and DM counterparts, and U.S. equities— predominantly growth and tech—are gunning higher. By contrast, EU equities are lukewarm, and EMs are outright struggling as balance-of-payment stress take down one domino after the other. In bonds, the U.S. front-end is held up by expectations that the Fed will keep trucking, while the belly and long end are edging sideways. In other words, the U.S. yield curve is, still, flattening. Finally, all measures of global macro-liquidity have rolled over; real M1 growth is falling, and CB balance sheet expansion is kicking into reverse. To boot, most other leading indices also are exhibiting weakness. If this doesn’t sound familiar, it means that you have been living under a rock this year. I have been recounting this story for several months, and I am getting tired of it. But we haven’t yet had the grand finale so it’s probably too early to abandon it, as much as I would like to. In summary, I think we are due a fall in U.S. bond yields, potentially in both the 2y and 10y but almost certainly in the latter. I reckon that this happens alongside, or right after, a final moonshot in the dollar. It should be a cathartic moment for markets, setting the stage for a different story.

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Sweet Irony

You will find no harsher critique of Mr. Trump’s indiscriminate use of social media than yours truly. If it were up to me, the president’s phone would have been deactivated a long time ago. Last week’s performance on economics, however, struck at the heart of a story economists and strategists have been circling for a long time. How far will monetary policy divergence be stretched in this cycle? Mr. Trump first suggested that other major economies—Europe and Asia—are unfairly manipulating their interest rates and currencies, before following up with a swing at Fed for making things worse by hiking rates. In short; the White House is suddenly spooked by the risk to the economy from a stronger dollar and higher rates. This is probably a reasonable political worry ahead of the mid-terms, but it is also sweet irony. If Mr. Trump wants to complain to anyone about the vigour of the dollar, he should start with a look in the mirror.  Aggressive tax and short-term inflationary tariffs in an economy with a near record-low unemployment and savings rate could only have one outcome in the end. A more assertive Fed and a stronger dollar always were obvious side-effects of such a policy constellation. 

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Watching Paint Dry

From the perspective of the big narratives, markets at the moment are like watching paint dry. In equities, EMs are taking a good’ol beating, but the MSCI World is no closer to breaking its range since the Q1 swoon on the back of Volmageddon. This is mainly thanks to a combination of steady tech-outperformance in the U.S, and sideways indecision in most of the major EU indices. In FX markets the dollar is bid, especially against EM currencies, but investors seem split on whether this trend will be sustained or not. Gun-to-head, I think the dollar can rally further, but as I noted last week, don’t ever place your FX bets based on what economists say. Finally in bonds, the U.S. yield curve is flattening, and despite endless discussion in financial media, we still don’t know the answer to the main question. Does the Fed care, and would an inversion stay its hand? I have discussed this several times on these pages, and the central point is simple I think. If a flattening yield curve is a problem for the Fed—and assuming that the rest of the world isn’t moving—it only has one option to reverse the trend; it has to slow down its hiking cycle, or halt it altogether. This possibility has been hotly debated in recent weeks alongside mounting evidence that the rest of the world is slowing. 

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