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Episode 25

Will The Fed Create A Disorderly Dollar?

Published on: April 21, 2020 • Duration: 17 minutes

This week we look at whether the huge monetary accommodation by the US Federal Reserve may end up driving the dollar higher and having a negative impact on global risk assets. It would appear that, by outgunning the other central banks, the Fed is making US assets more attractive to investors because they are backed by the central bank. 

  • Two months into the crisis and the US, Federal Reserve has rewritten the rulebook of monetary accommodation in order to stabilize markets. But are these actions in danger, driving the dollar dangerously higher? That's The Big Conversation. 

    As we've talked about before, the Fed has done a significant amount in terms of accommodation to try and offset the deflationary bust that has been ravaging the world. And with good reason, because when we look at the data, global data, but we'll focus on some U.S. data, we can continue to see just how shocking this impact has been. Firstly, we've got to the GDP data from China. Now, I know a lot of people don't necessarily believe the Chinese data, but nonetheless, this is nearly always been of growth around about 6 percent. And even the Chinese have admitted that the growth there is around about minus 6.8 percent. So an absolutely stunning reversal. Not surprising in many ways, given the lockdown that we've known the Chinese have gone through, and also other parts of the world are going through. Closer to home we got three big pieces of U.S. data last week. The first one and perhaps in some ways the most shocking, but again, perhaps not the most surprising, if you can say that in the same sentence, was the Empire State Manufacturing Index. This is obviously focused on the New York area, and it was down around about minus 78 versus minus 35 expectation. Again, uncharted territory in terms of what we're seeing here. Retail sales was expected to be down 8 percent. It fell down 8.7 percent. So that was in line in many ways with some very clear dispersion between large goods and even apparel. So clothing fell around about 50 percent, whereas we saw an increase in demand for groceries as obviously people stockpiled. But nonetheless, month on month, this was a surprisingly a worse or very weak figure. Industrial production - now we've got industrial production data going back over 100 years. The fall in industrial production massively outstripped what we saw in 2008 on a month on month basis. And it's the worst we've seen since the 1940s, in fact, since the end of the Second World War. But maybe in some ways, one of the reasons why we've had a good response, a fast response from central banks like the Fed is that the speed of this turnaround. When we look at this month on month data, it's unprecedented. When we look at the data year on year, if you go to, for instance, those retail sales year on year, it was worse in 2008, 2009. And maybe this is if you can call it a saving grace or a blessing, but the speed of this turnaround, because it was so sudden, it's allowed central banks and government authorities to react very, very rapidly and with significant size. Remember in 2008, that had been a slow burning recession that had been effectively on the cards for a couple of years because the first mortgage pressures really started to build two years earlier. And it took that sort of death by a thousand cuts with a final implosion around the Lehman crisis of 2008. This was October, November that finally got the central banks and the governments acting accordingly. Today, the move has been much swifter. And maybe that's something which is going to allow a little bit more support into risk assets. But I think all the key elements here is just what the Fed is doing. And what the Fed is doing is significant on a global basis. And I think this is where the risk for the dollar perversely lies. In so many ways the big question is why is the U.S. dollar not significantly weaker? We've seen the Fed announce all these various facilities that they're supporting various parts of the market. We can see that the Fed's balance sheet has expanded by two trillion dollars over the last two or three weeks, in fact, over this period that we've been going through. Now, compare that to the ECB. The ECB has also been active. They've announced QE, but the size of their QE is around about 500 billion in terms of the size increase in size of their own balance sheet. And so they're very much lagging. The Fed is very much in the driving seat here, and that should be pushing currencies, at least the dollar, should be pushing the dollar lower. Yet when we look at the DXY, why the DXY has gyrated a little bit, particularly when we've had the announcement of things like the 2.3 trillion junk bond buying facility. Speculative positions built up, and people went short against the dollar. But the dollar really has rebounded or at least stayed relatively static. And you can see this on the euro as well. The euro has had a few gyrations, but ultimately it still seems to be grinding a path lower. And as we've mentioned before, if you really want to see where the dollar's playing its strongest hand, it's versus the EMFX indices. If you look at the JP Morgan EMFX index, it's still very much close to those all time lows. And you can see some spectacular moves in things like the Mexican Peso, the Brazilian Real and the South African Rand. These three currencies have had significant moves and look like their move has not yet finished. And why is this happening? Well, we've already discussed this dash for cash in that the real world economy is still slowing down, even if the financial assets, particularly in the US, look relatively robust, considering the backdrop that we've got with the real economy is under duress. And that's what we're seeing with these emerging market currencies. There is still a crunch going on, countries are still very much in lock down. This means that cash flows at the corporate and the household level have been severely impaired, and the Fed has put in some operations to deal with this as a repo facility, there are swap lines in place. Not all these are in fact being used in any way, shape or form to the level that people had hoped. But they are in place, and this has certainly alleviated some of the issues with the G7 currencies. But emerging market currencies, they still remain on the back foot, and I think they're a better reflection of what's going on in the real economy. And that kind of in some ways brings us onto the next section, which is, okay, well, if the real economy is still under pressure, but financial assets are suggesting that things are not so bad, well, how do we trade this? Where are the freely floating markets? Where are markets that are not being at least distorted by central bank action? And I think this is also key to understanding just why the central bank, or the Fed's actions may actually lead to a much stronger dollar. So if the US is being distorted by the effects of the Federal Reserve, where can we find assets that might reflect the ongoing malaise across the global economy? Where are the pressure valves? I think the obvious place for that is to look in the foreign exchange markets, where despite the swaps and the repo facilities put in place by the Fed, we'd still expect to, I still expect, a lot of these emerging market currencies to come under pressure. We mentioned them before, things like the Brazilian Real, the South African Rand. These have fallen significantly so  this is dollar strength versus these currencies. These currencies have weakened significantly versus the dollar. It looks like they're currently going through consolidation phases rather than reversals. And I think we will see a new leg lower in these currencies versus the dollar. So dollar higher. And this is because the global economy remains in lockdown. This is the difference between the real economy, where we're seeing balance sheet impairment vs. the financial economy, particularly the US, which is being bid by the expectations of the Fed. We can also see this in commodities. Now, commodities have been under a lot of pressure. This morning we've seen another 20 percent decline in WTI, but that's to do with tomorrow's expiry. We're not seeing the same sort of move in the second month contract or in Brent, which is the global benchmark. So this pressure that we've been seeing is real in the commodity space, even if we ignore that front month move, and we've fallen to two multi-year lows in Brent. We've seen significant declines in things like copper. So we can see this still being expressed through the real economy such as commodities. Even though OPEC + has attempted to support that market. I think this reflects also that the emerging market bonds and I think this is the other big area along with FX, emerging market bonds, another space where we'll see assets reflect the ongoing weakness in the global economy. When the corporate bond market imploded in the US, we saw emerging market bonds sell off aggressively as well. And although emerging market bonds have recovered some of their poise, not nearly so much as US investment grade, which is up on the year and the US high yield. And I think that the emerging market bond space is one which is another way people will reflect the slowdown in global trade and the global economy, even if U.S. assets are being supported. But what about Europe? Should we be looking at European assets? And I think again, Europe shows just the difficulties in trading outside of the US market. And so what about places like Europe, for instance? Should people put money to work in Europe? After all, the ECB is doing some QE, although not maybe not at the same speed as the Fed, but they're still doing QE. Well, the problem with Europe, as we can see, is things like the banks, the European banks, they have broken through to new all time lows. They have been under a lot of pressure over the last two or three years. In fact, they've been under pressure since the euro crisis in 2011, 2012. The banks don't look like they're in recovery mode anytime soon. In fact, we should expect a swathe of nationalization across the banking sector unless, of course, they can come up with something like Corona Bonds, where the wealthier nations, particularly of the North, will support and bail out the countries of the periphery and the South. The problem with this is that once again, we're seeing a lot of rejection of this by certain parts of the of the eurozone, which is always been the eurozone's problem is that there's so many different vested interests that are very, very hard for them all to align. Christine Lagard has been put in place to try and bang their heads together, which we mentioned last week. But it's still proving very, very hard to get any unity. And we can see this in things like the Bund BTP spread. So this is the German Bund, 10 year yield and the BTP Italian yield. It widened out quite significantly as we started this crisis then as expectation for Corona Bonds came in, it closed up that spread, but it's been widening out again, reflecting this uncertainty, this lack of ability to agree anything within Europe. Now, it doesn't mean that the US is necessarily that much better when we look at the banks in the US, the BKX has been under a lot of pressure itself and in fact has declined quite dramatically and has been making new lows. And it's particularly significant when you look at the BKX versus the broad markets such as the S&P. The BKX is under significant pressure. Now, the key difference here, though, is that with the Federal Reserve is there really to look after the banks. And I don't think that the Federal Reserve will therefore want to go into negative interest rates. I think they'll lock the front end and allow the back end to move. Now, that still means you might get a flat yield curve in the US, and it might even go into negative territory. But the Federal Reserve will do what it can to look after the banks. In fact, many the facilities that have been put in place actually quite a decent margin with very, very little risk to the banks to start doing loans into the real economy, which so far have not quite hit the mark yet. But i think the real key here is that if you think of the world very, very simplified and I'm gonna simplify it beyond recognition. But let's pretend we had a two world, two assets in the world that you could choose from. One is U.S. bonds and one is emerging market bonds. Now, in this environment, would you put your money into the bonds of the US, which are backed infinitely by the World Central Bank, the Federal Reserve, who are basically out there buying all the assets that are required to stabilize markets? Or would you put your money into emerging market bonds, which are basically exposed to the vagaries of the Coronavirus and this massive slowdown in the economy, the global economy, particularly the exports of commodities and the finished goods of which they are kind of the leaders? And also, would you expect their central banks be able to deal with this through liquidity? Well, they can't because of inflation problems in the risk of destroying their currencies. But nonetheless, that's exactly what's happening. Is it given that choice? I think people are voting and they're basically funding the cash towards the US because of the Fed doing QE. And the more the Fed does QE, the more attractive the US becomes for foreign foreign investors because it looks like you want to buy the things the Fed is buying. And so this is many ways is the conundrum for the U.S. Fed, which is that it needs to print money in order to support risk assets and also it needs to try and keep a lid on the dollar, keep the dollar down. But because the US is backstopped by the Fed, it's actually encouraging people to invest in the U.S. markets. I mean, who wouldn't buy all the assets the Fed is buying? You've probably got only upside in those, even though the yields and the return, the dividends look poor. The actual outlook in terms of capital gains or at least capital protection looks very good. So the irony here is that the more the Fed prints, the more money wants to come to the US. The more the Fed prints, the more risk it has of creating a disorderly move in the dollar to the upside. Not because of the dollar strength itself, but because of the weakness in other emerging market currencies in particular, and maybe some of the commodity currencies as well. And if you look at this, you know, the S&P, we talked about this last week, it's at a key juncture. It's between the 50 and 62 percent retracement. This is in line with pretty much every rebound after every major sell off that we've seen in history across nearly every major market. This is a very common a garden rebound that we've seen. The Fed wants to keep this going. And the big question for a lot of people is, can the response from central banks, particularly the Fed, actually be greater than the impact of the virus itself on the economic impact? And as I mentioned earlier, the speed with which this has happened has allowed the Fed to respond very, very quickly. That might be a saving grace. But at the same time, this is focused specifically on the US with some swap lines and repo facilities for foreigners. But that doesn't mean that these foreign economies are going to necessarily benefit. In fact, as we see with the emerging markets, they can't print their currency, or if they do, they risk the currencies declining rapidly and the risk significant inflation. So they have to be very, very careful. So therefore, they are completely exposed to the ravages of the economic slowdown. And then people say, well, what if these countries default? If they default on their dollars, the short dollars, then that loss of demand for dollars. Shouldn't that mean that the dollar's weaker as well? In the short term no. The risk here is a bit like margin calls at a clearing house. When you have a normal market, you might have to put 3 percent margin against a future. Volatility picks up that goes to 7 percent. And then if you get a default in one of the counterparties, they might put it up again to 10 percent or something like that. Similarly with defaults, countries don't like to default on debt. Argentina knows how to do it. They enjoy doing it. But remember, Greece tried very, very hard not to in fact, kind of fudged around that one. Most countries don't want to default. Countries will do sporadically. But when one country defaults, that effectively makes all the other countries more worried about being able to pay down the debts. Demand for dollars goes up. If one country defaults on its dollar denominated debt. It's only if you get a unified cluster of defaults across a large number of emerging markets, or a large number of even corporates, global corporates. At that point, you might wipe out the demand for dollars. But until then, each dollar, each default creates increased demand for dollars. So this whole framework of the dollar that the Fed has put in place where the dollar could actually go higher the more the Fed makes the U.S. more attractive is actually destabilizing or potentially destabilizing. The key is a disorderly move in the dollar. If the dollar moves at a grinding rate over the next few months it doesn't matter. But if the DXY got to, let's say 110 or the euro got to parity in the next few weeks, that would create a problem for global risk assets. So this is a simple conundrum. Damned if they do, damned if they don't. If the Fed doesn't intervene, then they're taking the bid out of risk assets. They'll roll over. If they do intervene, they might put a bit into US risk assets, but that increases the demand for dollar denominated assets and also undermines in many ways some of the emerging markets and other global risk assets and therefore creates a distortion which ultimately might lead to the dollar's strength and weakness in the economy. So how to hedge it? Simply put, gold is one of them. If the Fed are locking interest rates, but they could potentially create an inflationary bottlenecks as that liquidity gets into the market and demand picks up. But supply is not coming through. But yields are kept with a lid on. Then you could see inflation going above yields. You get negative or falling real yields and falling real yields has been good for gold, so gold should continue to do okay. Although the speculative positions are very long in gold so be aware of that. And then the second thing is clearly in those currencies I would still look to play a strong dollar or dollar strength. But what I'm really playing here is some EMFX weakness. We've seen two or three already. Those are the sort of places you want to go where it looks like they're consolidating on a move weaker. So this is things that the Mexican Peso, South African Rand, Brazilian Real, many others that are already on what looks like a path towards weaker currencies. That's going to be their pressure valve. I think that's how we can play this, because there is a risk that the Fed overplays its hand and gets the exact opposite of what it really wants, which is actually a disorderly move in the dollar to the upside.