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Episode 79: Will a dollar squeeze kill markets?

This week we review the recent strength in the US dollar and the flattening of the US yield curve. Could this be an inflection point for the reflation trade or has the market overreacted to a few slightly hawkish comments at the recent FOMC? If the dollar breaks some key levels, then the rally could turn into an unexpected rut. In this week’s Chatter, Jeoff Hall, Managing Economist at Refinitiv, discusses the outlook for US employment and the recent data conundrum, where there are signs of both extreme slack and extreme tightness.

  • The US dollar has surged since the last June FOMC meeting, and this now brings into contention a number of key technical formations which have significant implications for risk assets. If the dollar index is completing the right shoulder of a reverse head and shoulders, then a break of the neckline would take the dollar back to around the 99 level. Investors don't need to have a bullish or bearish view on the dollar, but they need to understand the impacts that a dollar squeeze would have on markets.

    [00:00:30] So far 2021 has been dominated by the reflation trade, but as we've argued before, this is not really true reflation, because it was not the globally synchronized type of growth that we've seen in the past 20 years, particularly from 2001 to 2008. That growth was led by China, whose massive fixed asset investment program saw sustained rises in commodity prices, which then had an impact across all global markets, with a higher beta emerging markets with the commodity or heavy industry bias outperforming. Today's reflation trade has been much more about inflation rather than economic growth. It has seen many reflationary assets moving higher. But much of this has been about bottlenecks and base effects, with U.S. dollar weakness helping to supercharge that narrative. One of the clearest signs that this has not yet been the same type of reflation that we've seen before, was the underperformance of EM equities and currencies compared to previous reflationary events. During those periods, dollar weakness was a consequence of global growth. Recently, reflationary assets have been rising as a consequence of dollar weakness, and that is a key distinction. Today's version of reflation has seen the dollar on the back foot because of the relative expectations about monetary and fiscal policy in the US, Europe and China. The dollar was primarily weak against the euro, plus a few other G7 currencies and the Chinese renminbi, rather than the broad-based emerging market complex. Dollar reflation can eventually turn into global reflation, but it's far more susceptible to positioning when compared to the China led reflation of the past. Therefore, if the dollar strengthens, risks will spill over into many of the trades that had been performing based on the expectation that growth would take a lasting hold. We can see from the bond market's reaction in both the absolute level of yields and the flattening of the yield curve, which has been quite pronounced in the 5-year, 30-year portion of the curve that the current move in growth proxies could come under pressure. The so-called hawkish comments from the Fed, and that's relative rather than an absolute statement, have also had a significant impact on the front end of the U.S. government yield curve, with 2-year yields finally breaking out of that tight twelve-month range. At the same time, longer-dated yields and inflation expectations have been falling because the market has started to price in a tightening of financial conditions. Now of course, this could all become a self-correcting mechanism. If the threat of a Fed tightening causes too much impact to risk assets, then the Fed are unlikely to follow through on their current intentions. We've seen the Fed flip-flop on policy before, but it's clear that flattening yield curves are bad for banks. In the US the ratio, the bank's index and the SPX has been tightly following the performance of US 10-year yields. These yields have recently hit their lowest level since February and have been testing the 12-month uptrend. In Europe, the ratio of banks vs. staples, in this instance the food and beverage sector, has been following the fortunes of the two-year versus ten-year section of the German yield curve. When the yield curve flattens, banks underperform and staples outperform. Currently, however, this may be more about pricing out the inflation reflation of the US versus the rest of the world. US yields had widened out versus Europe, but last week that spread took a significant leg lower. This wasn't about global reflation, at least it hasn't been so far. This was mainly about the outperformance of US monetary and fiscal policy. If inflation has been mainly about base effects and bottlenecks and the expectations of excessive US policy, then the risks were always that there was going to be a reward to the US for its success driving capital back to its shores. In the meantime, as we've outlined in recent episodes, large-cap US corporates were still favoring buybacks over capex. Those buybacks have been concentrated in the US tech sector. Whilst the higher yields into March of this year were a headwind for tech stocks and saw the S&P 500 outperform, the ongoing buyback bid is concentrated in the tech sector, and that is a headwind for the reflation rotation trade out of tech names and its commodity and value plays. And that's why we need to be aware of a potentially significant move for the dollar. Now, this isn't a prediction, rather, it's a roadmap of what to expect if the dollar does break some of the key levels. So what are those levels? Well we started off this episode highlighting the US dollar index, around 57% of that index is the euro, so it should be no surprise that the euro is carving out a similar formation. The key level to watch is just under 1.18. A clean break could see the euro versus the dollar dip back to 1.10. The Aussie dollar has already been testing the key seventy-five level that we've highlighted in previous episodes. If successfully broken, it would suggest a move to seventy is very possible. And over a much longer time period, we would then have to monitor if this was part of an even bigger topping formation, which could take the Aussie dollar back to sixty. And the one thing to remember here is that technical formations don't mean that these targets will be met, but they do increase that possibility if they're broken. The technical angle should complement the fundamental angle. And it's the latter which has come under pressure from the Fed in the last week, bringing these formations into play for the first time. The Chinese Yuan has also been retracing some of its recent strength. China has recently been redoubling its efforts to talk down commodities. The strength in their currency has been more than offset by the rise in commodities as a result of dollar weakness. And this has seen imports move higher because of rising prices, not volumes. Chinese producer price inflation has been surging at a much faster pace than consumer price inflation, and that will be impacting margins. In fact, China merely reflects a problem that many producers are facing the world over. We have not seen substantial growth in global demand because the global economy is still recovering. It's not yet returned to its former trajectory, despite the impressive rebounds off the lows. Therefore higher input prices are having a negative impact on growth, and this has been reflected in subdued industrial production figures. And if the banks are hoarding cash instead of lending, then it's hard to generate lasting inflation. The global corporate sector remains very defensive at the moment. All of the currency moves we've highlighted would imply that the US dollar is going back into the range, and as long as these moves are relatively gradual, then the implications for the broader market will be manageable. The key risk, it's the positioning within reflation assets which would come under significant pressure. As we've already seen, emerging market equities have not performed as well as expected during recent bouts of dollar weakness. They are no longer getting the benefit of the weaker dollar whilst remaining susceptible to a stronger US dollar because the high levels of outstanding dollar-denominated debt. The rise of the tech sector within emerging market economies partly explains why these equity markets have not felt the same benefits from dollar weakness. Also, whilst China was heavily involved in the bounce in commodity prices last year, this is not the growth at any cost policy that benefited EM in the past. China has repeatedly outlined their policy stance away from investment towards consumption, turning even more cautious as commodity prices surged. A stronger dollar will also be a test for copper. Copper is expected to be part of a mega-trend within the green technology space. But again China has been ahead of that move. During this rally, copper has divorced itself from many of its longer-term relationships with the Aussie dollar or its ratio with gold compared to the US ten-year yield. Copper's long-term thesis remains strong, but further dollar strength will undermine the weak hands. We have to be prepared for a basic 38% Fibonacci retracement of copper's rally from last year's lows, which would take copper futures back to around 380. But to put all of this into perspective, so far the dollar has just retraced a few percent from the recent lows. The big move would occur if the key levels were breached. Even then, we're still talking about the dollar moving back into the range and not about a significant new high. The Wall Street consensus for the dollar in 2021 was almost unanimously bearish. Positioning is not as extreme as the strategist's view, but overall, this has been a one-way bet for a weaker dollar. It's not however, the level of the dollar that really matters, it's the speed of the move, a sudden move higher would unbalance the current positioning, and that's a real risk if the key levels are taken out. Volatility in the currency market has started to pick up, but remains at the lower end of the five-year range. Dollar calls or euro puts are likely to become more popular. The euro US dollar one-month risk reversal has just swung in favor of puts over calls, meaning implied volatility for the downside is higher than the implied volatility for the upside on the euro, but it remains close to the middle of the range. Downside on the euro is not excessively expensive by historical standards, so there's a lot to play for. If longer-dated yields continue to edge, lower than tech stocks should outperform once again. Banks have been under pressure and this is likely to continue if yield curve continues to flatten, though, these look like a bigger risk for the US market where the prior curve steepening and inflation expectations were the most aggressive. If copper breaks lower, then the implications for mining stocks are clear. The European Basic Resources Sector has been closely tracking the copper price for many years. Overall, it would mean that policymakers such as the Federal Reserve are trying to keep a lid on volatility. They don't want the dollar to move in a disorderly fashion. If it's too weak, too quickly we have an inflation problem. If it's too strong, too quickly, we have a problem with tighter financial conditions. Fortunately, these appear to be self-correcting mechanisms. One extreme creates another offsetting extreme, which mitigates the implications from the first. Policymakers can't afford to lose control because if we get an excessive move, then the unwinds of existing positions could overwhelm markets leading to a VAR shock and yet another round of support. If policymakers are constantly having to provide support, then it means they never get round to providing true stimulus that helps economies finally break free from a decade of slow growth. The recently weak US dollar was creating inflationary pressures. But now we have to be on guard that we don't get a surge in the dollar, that also causes a wide range of other problems for markets. And one of the most important considerations for policymakers is the state of employment. At the moment, there's a bit of a conundrum. There are many signs of a weak jobs recovery, but at the same time, US companies are struggling to fill job vacancies. I spoke to Refinitiv's US economist Jeff Hall about the current state of the labor market.

    Roger [00:10:47] The performance of the labor market is one of the main pillars of the Fed's policy objectives and a key consideration when thinking about future levels of inflation.

    Jeoff [00:10:55] Well, the Fed operates under a dual mandate, and that is full employment and stable prices. So as the Fed executes or prosecutes monetary policy, it's it's focusing mainly right now on the full employment side of the dual mandate. And we've just gone through a tremendous exogenous shock, monetary policy has shown great success in staving off a more disastrous outcome with employment. And so now the Fed is looking for full employment again to say that it can start removing policy accommodation down the road.

    Roger [00:11:35] The US non-farm payrolls data is still one of the most important data points in the US, and the scale of the pandemic shock is taking a long time to work through the data releases, making it difficult to assess the speed of the recovery. The next release is on Friday, the second of July,

    Jeoff [00:11:50] After the massive drop in April of last year, we've repaired the market in fits and starts. And then we you know, one of the fits was in the late quarter, the fourth quarter of 2020. Since January, however, we've been increasing non-farm payrolls at a pace of about 540,000 per month. Again, the disappointment in March and April or rather April and May, so now the market is perhaps preconditioned to expect a disappointment in June as well. Current market consensus puts non-farm payroll growth at about 600,000. That's not quite enough to keep the three-month average pace above 500,000. We expect that we will see diminishing returns in the labor market where as we come further and further away from that shock that we had last April and May, and the job growth will start to average somewhere closer to 400,000 and then 300,000. Those are still impressive numbers. But at that rate, it may take until say September of 2022 before we even get back to where we were before the pandemic. So there's still a lot of, a lot of convalescents to happen in the US labor market.

    Roger [00:13:13] There is a conundrum in the US labor market. Many statistics suggest there is still significant slack, but other data points suggest that companies are struggling to hire workers, fueling the debate about whether the labor market is currently loose or tight.

    Jeoff [00:13:26] I would say that right now over this domain, the labor market remains loose. There are some 15 million Americans that are still receiving benefits under one or more of the unemployment compensation schemes. You have pandemic unemployment assistance or pandemic emergency unemployment compensation. We've seen a very big drop in state benefits and the trend continues to point lower. So we should see some normalization in that side of the labor demand, but the fact remains that there are still, there is still a large percentage of the population still collecting benefits. So in that regard, I would say the labor market is, remains slack. And that tells us that the Fed still has room to maneuver when it comes to leaving monetary policy at the zero bound. As you said, there's a conundrum between the number of job openings and the number of unemployed persons in the United States. So we've topped nine point two million job openings through April. That's very close to the number of unemployed persons when we look at the labor market, the Bureau of Labor Statistics monthly data. So that one-to-one comparison that says that you are at full employment. However, we think that's a short-term dislocation between the two series, and that unless we see hires, the number of people actually landing jobs rise at the same pace as we're seeing job openings, then we are not at full employment.

    Roger [00:15:06] The market response to the June FOMC meeting has been quite dramatic, fueled by one of its dovish members appearing to take a more hawkish stance. But given the slack in the labor market, did the market overreact?

    Jeoff [00:15:18]  We saw from the summary of economic projections, the so-called 'dot plot', that we've pulled forward the timetable for the first rate hike now into 2023, and you had seven FOMC participants who now think it's appropriate to raise rates in 2022. The market was not prepared for that. The market is on tenterhooks waiting for the so-called lift-off, waiting for the end of, or the tapering of the large-scale asset purchases. So the market did not take this news well. It came to a head again on Friday when St Louis Fed President Bullard, who is an erstwhile dove, started waxing hawkishly and saying that the time has come for the Fed to start moving off the zero bound. And it came in two parts. One, the fact that he mentioned it, and two, who mentioned it was the one that we think is the most dovish member of the Fed. He has a vote in 2022, so it wouldn't surprise us now to see him vote in favor of rate hikes in 2022 and not just at the end of 2022, but perhaps earlier. So the market understandably had a rather nasty reaction to those comments. I think it's it's somewhat balanced out this week, cooler heads have prevailed, but you've seen some massive whips in the shape of the yield curve, particularly the 5 30 segment.

    Roger [00:16:47] The Fed committee is understandably being influenced by some of the recent moves in inflationary assets. Markets, however, are skeptical that a tighter stance is appropriate with yields in the long end of the bond market declining and implying growth will fall. What is now key is whether other global central banks follow the Fed's lead, which they often do, and embark down a path implying tighter global financial conditions ahead. And if you have any market questions that you'd like answered, please put them in the comments section and we'll have a go at tackling some of them in future episodes.