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The Big Conversation

Episode 121: Is the dollar about to surge?

This Roger Hirst looks at the dramatic move in the Japanese Yen that is testing some key levels. Will the Bank of Japan keep a cap on yields and let the currency go? Even the Euro is testing a multi-decade uptrend. A strong dollar may not be your base case, but you need to be aware of its potential and the implications it has. And if the Yen is on the move, will the PBoC allow the Yuan to decline as well?

  • Roger [00:00:00] Whilst investors are currently focussed on inflation and interest rates, there are some absolutely huge levels that are being tested in the currency markets with the dollar index, the DXY testing a 20-year trend. So what are the implications if the US dollar breaks higher? That's the Big Conversation.

    Roger [00:00:20] The dollar index is mainly the Euro at a 57% weighting, the Japanese Yen is the second biggest component at just under 14%. Whilst the DXY is testing a key trend level, it's these two currency behemoths that are of real interest here. Now although most of these lines on charts are just that, they're lines on charts, they still provide some anchor points from which we can evaluate a few 'what if' scenarios. Chart patterns themselves don't define the direction of an asset, but they are a useful tool for trade entry and exit points. They also help us to evaluate the potential for price action. So we're going to first start with the Yen, which is the third most active global currency. And what's been going on here is quite remarkable. So a move higher in the USD Yen chart represents Yen weakness. And last year, USD Yen began to break through the 50-year downtrend on the logarithmic chart, something that we pointed out in a previous Big Conversation. This year it broke out of the 30-year downtrend from the dollar high that was in place just after the peak in the Japanese equity market of 1989. USD Yen has surged from 115 to 128, its lowest level in 20 years. The most recent leg in this move has seen the longest winning streak for USD Yen in its history, which by Tuesday, the 19th of March was 13 consecutive days. Basically the first 13 trading days of Japan's new financial year. As we filmed this on Wednesday, the Yen was trying to break that streak. USD Yen is now breaking through the neckline of a reverse head and shoulders pattern. Now, once again, we should point out that these patterns don't define the direction or size of the move, but they can help us to evaluate the risks if they play out in a classic pattern. So to demonstrate this, here's the reverse head and shoulders on the US 10-year yield. Now, for most of the last couple of years, I've been in the deflationary or disinflationary camp. I was probably expecting bond yields to drift lower. However, I regularly highlighted in past Big Conversations the risks for significantly higher bond yields if this pattern broke. We said it targeted the 3% to 3.25% level, and so far, it's touched 2.9%. So the point here is that we can use some of these patterns to assess risks to our core views or even to look for potential inflection points. Therefore, returning to the USD Yen pattern, we can target a potential level for USD Yen that's in excess of 160. But this is a long-term pattern, and it should take some time to reach these sorts of levels. Indeed, as we've just pointed out, with regard the record winning streak for USD Yen, this is now a stretched market with a relative strength indicator of USD Yen at multi-year highs. So we should now be looking for a breather. And this is what happened on the US 10-year yield after it first broke out. It retested the neckline, forcing many bond bears to close their positions before then screaming higher over the last few weeks. So what's behind this weaker Yen? Well, it's mainly about divergence between central bank rate policy. Kuroda and the Bank of Japan are defending the 10-year bond yields in a 25 basis point range, around zero. Yields are currently testing that upper boundary. If you're defending yields, you have to let your currency move freely. However, as we've seen with many caps and pegs before, if the pressure becomes too extreme, policymakers can step away. If they did, that JGB yields should rise and the Yen rally, and that's now a constant and unpredictable risk. With Japan capping yields and U.S. yields moving higher, the yield differential between the markets has been widening out. So for Japanese investors looking for positive yields, there are far better opportunities to be found in overseas markets as long as the cost of hedging the currency risk is not too high. And many parts of the Japanese economy are still mired in debt, so that higher funding costs still appear to be a bigger worry than higher inflation, at least for now, anyway.

    Roger [00:04:01] So now onto the Euro. This is also testing its own arbitrary line in the sand, having recently broken through the uptrend that's been in place since the early 2000s, just after the Euro's entry into the global markets. And using a basket of pre-Euro currencies that trend line actually extends back to 1985. The European position is nowhere near as extreme as Japan's, but the region is still lagging the policy shift of the United States. German 10-year yields have bounced back from negative territory, but the spread between Germany and the US is near the two-year highs, favouring US over Germany. Furthermore, many indicators such as the German ZEW survey, suggest that Europe is teetering close to recession. The difference between the ZEW and the US ISM survey today is quite dramatic. Germany's industrial base benefits from stable input prices but recently that's been far from the case. The year-on-year change in the German Producer Price Index recently touched its highest level in 50 years. Whilst inflation may be inflating the value of both imports and exports to above pre-pandemic levels, higher input costs are also eroding margins. So there are clear risks that both the Yen and the Euro could fall further given the economic policy divergence, but it may be that the yield differential to the US will now take a bit of a breather. US 10-year yields have reached the top of a long-term trend on the log chart, dating back to the early 1980s. Most business surveys in the US do suggest a robust economy, but things are moving at a rapid pace. When we look at the combined University of Michigan Consumer Sentiment Survey and the NFIB Small Business Optimism Survey, we are at levels that have often been recessionary in the past. Much of this weakness is down to the consumer sentiment, which has fallen well below the trough of the COVID pandemic, and consumption is the key driver of the US economy. Furthermore, although we can't say whether inflation has peaked yet, and this is usually a lagging indicator, we can know that historically the peak in inflation, such as CPI, has occurred in the middle of a recession on almost every occasion since the 1970s. Many people want to point out the strength of the ISM is another reason that the US is a long way from a recession, and this is indeed true over the last 20 years or so, where recessions have generally only occurred when the ISM has dropped significantly below 50, with many false readings under that level with no subsequent recession. However, if we go back further into the 1960s and 1970s, that period of high or rising inflation, we can see that recessions occurred at times when the ISM was at or well above the 50 level. So perhaps the ISM gives different signals during periods of high inflation. And another indication of just how unusual this period is and how we should be cautious about applying the metrics of the last 30 years is the speed with which the recent yield curve inversion occurred after the initial rate hike. Normally, the inversion takes place towards the end of the rate hiking cycle. On this occasion, it occurred in the same month. That's the fastest hike to inversion since the 1950s, and the fastest before that was one month later in 1980, which again was a period of higher inflation. So whilst the dollar and US yields are moving higher, we need to be aware of just how stretched they've become, and we should be prepared for a retracement. But if these currency patterns play out over a longer-term, then the risks of a strong dollar are clear. The consequences of previous dollar surges ranged from the Asia currency crisis in 1997, the dot com bust around 2000 and the Great Financial Crisis. Some of these moves have been coincidental, while some of these moves were initiated by a stronger dollar. And we should also watch the Chinese Yuan. The Yuan has often depreciated after prolonged bouts of Yen weakness during the last decade. Now whilst it's very unlikely that the Yuan will depreciate today as much as the Yen of the mid 1990s, there was a substantial move lower in the Yuan against the US dollar on Tuesday, when the Yen was falling by over one percent, and the Yuan chart also has the making of a reversal formation.

    Roger [00:08:05] So we've already had some very big moves in developed market currencies, and some key levels have been breached. But we've started to get very overstretched in some of these pairs, especially USD Yen. The U.S. economy does appear to be much stronger than these other regions, but that strength may be more precarious than meets the eye. But regardless of whether people are dollar bulls or dollar bears, there are always risks from a US dollar surge. Now, that might not be anyone's base case, but as we've seen with the US 10-year yield this year, momentum can build very quickly. So a risk-off hedge, therefore, could be to own calls in the US dollar, not for a short-term move, but as protection against the potential damage that a disorderly surge could have across many global risk assets. And if you have any questions about this episode, financial markets or the economy, please send them to FMT@LSEG.com.