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The Big Conversation

Each week we examine major themes driving the markets and use Refinitiv’s best-in-class data to assess the risks and opportunities for investors. Powered by Real Vision.

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Episode 17

The dollar surges as the virus goes global

Published on: February 26, 2020 • Duration: 16 minutes

This week we look at the causes behind the US dollar’s rally. Is it just powered by the spread of coronavirus? Or were their issues that pre-date the virus that are additional tailwinds for the dollar? The market chatter looks at why central banks fear a surging dollar and which markets are most at risk, with commodities and emerging market particularly vulnerable. And the whisper updates the coronavirus outlook, combining the risks of a strong dollar with the spread of the virus.

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15:55
  • [00:00:04] The Corona virus outbreak is now going global and the U.S. dollar is on the move, taking the dollar index to the DXY to its highest levels since 2017 before pulling back on Friday. Is this just a short term reaction to the virus? And if it's not, why should we care? That's the big conversation. The dollar index or the DXY is still seen as a benchmark, even though it's not necessarily the best representation of the U.S. dollar. Nearly 50 percent of the index is the euro, whilst the Japanese yen accounts for nearly 14 percent and British pound another 12 percent. The index has gained about 3.7 percent from its lows in 2020 to the highs. Meanwhile, the JP Morgan Emerging Market FX Index has been making new lows. Now that represents a new high in the US dollar. Now, an absolutely key factor here is the U.S. dollar was strengthening in both indexes well before the virus outbreak started to properly impact markets, with JP Morgan emerging market FX index testing is all times lows at the end of last year. In fact, in an episode of The Big Conversation on the 27th of November 2019, we outlined the divergence between the performance of equities and bonds, which are implying a reflation trade versus the performance of Asian currencies, which were not. Equities were then, and in many ways still are, at least until Monday's price action, responding to the injection of liquidity first by the Fed last year through its repo operations that added around about $400 billion in short term facilities. And then secondly, the People's Bank of China has responded to the coronavirus with its own substantial injections. Now that prior rally in equities was not, therefore, a sign of an economic boom, even though there were many signs pre virus that a number of lead indicators were trying to turn higher. It was simply the age old response in which equities and bond yields have generally rallied when QE style policies have been in force. Over the last decade, equities have preferred a combination of low growth and high liquidity rather than strong economic growth. So how should we currently interpret U.S. dollar strength? And what are the impacts? And we'll cover more the impacts in the next section. In a November episode we also talked about the US dollar smile and currencies which are generally higher beta tend to rally when there is a globally coordinated growth and vice versa. So to recap that U.S. dollar smile. When there's runaway growth in the U.S., the U.S. dollar can be strong as long as that growth is focused within the US. And some of the dollar strength of the last 18 to 24 months is due to US tax changes initiating a one off fiscal boost for the US. U.S. dollar strength on the election of Trump in 2016 anticipated U.S. focussed strength. As just mentioned, the U.S. dollar is often a weak when we have periods of synchronized global growth i.e. a boom or reflation period and when there is synchronized growth, investors hunt out better returns in overseas markets than can be found in the US, and that drives a demand for high beta currencies, which are often found in emerging markets. Rather than this being U.S. dollar weakness, this is actually global strength, emerging market effect strength, and the US dollar is also usually strong in periods of global weakness or recession. And that's where we get the repatriation of capital and a search for safety that often helps drive up demand for dollars. We saw a dollar surge during the great financial crisis, even though the US itself was at the epicentre of that meltdown. What we're seeing in today's U.S. dollar strength is a combination of relative domestic strength and an element of capital flight, plus the continuation of that slowing commodity cycle that impacted emerging market currencies for much of the last year. The currencies that are most under pressure today outside some of the EM basket cases, those with a heavy reliance on commodities, so things like the Brazilian Real, the Chilean peso and to a lesser extent the South African rand, plus the Australian dollar, which are all in the backfoot at the end of last year. And this hasn't changed. The Mexican peso, on the other hand, which is not reliant on commodities has done a lot better than those other currencies. What is new, however, is that some of the supposed safe haven currencies have been significantly weaker in the last couple of weeks, and some of the difficulty in interpretation here is that whether the weakness in the euro, the Swiss franc and the Japanese yen are a reaction to domestic problems or whether they were acting as funding currencies, reflecting a demand for overseas assets such as the US equity market. And perhaps the most dramatic move that we've seen has come from the yen, which finally broke through its five year resistance. And a rising line on this chart denotes U.S. dollar strength and yen weakness. The yen did react to macro data and the move was on the back of a shocking Q4 GDP print of minus 6.3 percent year on year when 3.8 percent had been expected another downward revision to the previous quarter. Now, this number, as noted, was for Q4 2019. That's well before the impact of the Corona virus. And though perhaps the scale of the decline should not actually be that shocking, and that's because in October, Japan raised its sales tax from 8 percent to 10 percent and household expenditures took a significant hit, very similar to the experience of 2014 when they last raised that sales tax. Retail sales took an even bigger hit this time round. And GDP dipped into negative territory in 2014. So it's no real surprise that it's done so again today, but the size of the hit was way beyond most people's expectations. And if we compare gold to the Japanese yen, the two have been in pretty much lockstep until this year's divergence, i.e. the yen weakness is a clear break from the last five years pattern. Previously, when global markets were under pressure, Japanese investors here are significant global creditors, tended to repatriate their capital. We did see a hint of that in Monday's price action. But maybe the price weakness in the yen suggests that Japanese retail investors aren’t pulling up the drawbridge but are now desperately searching for overseas opportunities and are anticipating another round of domestic financial accommodation by the Bank of Japan. The euro is the other key currency, which is under pressure, and this may indeed reflect the pressure that Germany's export dominated economy is facing from both the ongoing and intentional slowdown that China was undertaking last year as well. The heightened concerns, the global supply chain will remain in lockdown for the foreseeable future. A couple of weeks ago, we suggested that the euro should at least test the two year trend, which in fact it has indeed done, and that a short position in the euro was a better way of playing the problems that Europe faces rather than being short the equity market. And the DAX remains, at least it did until Monday, remains close to the all time highs, again boosted by those liquidity injections. The euro has attempted to bounce off the trend with a reversal in the macro data that we saw on Friday. And the euro will eventually break this trend. At least it should do whilst the coronavirus is still impacting markets. But something that we've noted before. Currency volatility remains close to the historical lows, and this implies that Ranges will want to try and hold even as we see markets taking a hit this week. But this previously low volatility environment is another reason why the break in U.S. dollar yen is particularly notable. As we saw only last week, it was the turn for the US data to fall below expectations, with the preliminary market PMI dropping below 50 for the first time the last five years, well short of the expected fifty three point four figure. And whilst it may well be true that the benefits of the US fiscal stimulus are now wearing off and that the US economy is playing catch up to the downside, the Fed will not be far behind if they think that a real slowdown is imminent and investors know this of the experience of last year's repo incident. Though this could be the week which finally tests that bullet proof aura of the S&P and the Nasdaq. But how to play a global slowdown? Currency and bonds are still the cleanest plays, even if equities now appear more vulnerable. Perhaps the most obvious one that we've highlighted before will be the Korean Won and the news flow on the coronavirus has now shifted and South Korea is one of the new fronts that has opened up. The currency has been weakening again and is again testing that huge downtrend that's been in place since the Asian crisis of the 1990s. So if the virus continues to spread globally, then currencies that are on that front line, are embedded deeply into the supply chain or are key commodity countries will be the currencies that remain under extreme pressure. 

    [00:08:40] Whenever the dollar squeezes higher, there's always a lot of chatter about the potential fallout. A surging dollar tightens global financial conditions and central banks in those circumstances often intervene as they did in early 2016 when it looked like the dollar was getting out of control. But in terms of the real economy, the U.S. accounts for roughly about 15 percent of global GDP in a slightly lower percentage of global trade. So why does U.S. dollar strength get people so worked up? Well, that's because the dollar has an outsized influence on global finance. Up to 40 percent of invoices by non-U.S. countries and over 60 percent of central bank reserves are in U.S. dollars. A large proportion of global derivatives transactions are priced in dollars, which the Bank of International Settlements has estimated as having a gross value in excess of 500 trillion dollars. Many countries have issued their debts denominated in the U.S. dollar. Currently, there's a record 14 trillion of cross-border U.S. dollar debt, with some estimates more than doubling that number when including off balance sheet transactions. And a strong dollar has often been a precursor to many of the major financial crises that we've seen over the last 40 years, such as the Asia crisis and the dot.com bubble. And the performance of the MSCI Emerging Market Index versus the S&P 500 has generally ebbed and flowed with the performance of the U.S. dollar. The strong dollar has generally seen emerging markets underperform, developed markets and in particular the US. And you can see that clearly in the performance of the local Brazilian equity market, the Bovespa compared to the MSCI Brazil index, the MSCI Brazil index, of which many Brazilian ETF s are based, is priced in U.S. dollars. And because of this it has significantly underperformed the local market. And when the dollar surges, and the speed of the move in the dollar is key, then commodity prices tend to fall. And this was the driving force behind the oil and commodity bust in 2014, in which a rising dollar coincided with oil prices halving from $100. And this is one of the key dynamics behind the shale patch bust and subsequent profits recession in the US in 2015. But it wasn't just oil prices that were impacted back then. Broad based measures of commodities also came under extreme pressure, with the declining copper prices helping to form the long term uptrend, which again today is coming under pressure. Both copper and oil prices have recently been back under pressure due to the corona virus outbreak. Both have so far managed to bounce from key support levels. If the U.S. dollar. can their properly breakout to the upside rather than grinding higher as it has done for most of the last two years, these support levels will be broken. Sectors such as the European basic resource sector and U.S. high yield corporate bonds will come under pressure. High Yield energy is one of the largest sectors within the high yield universe whilst the European resource sector versus the broader market of the STOXX600 looks like it's breaking down at this moment in time. Dollars basically have become the plumbing for global finance largely through the euro dollar system. But since the financial crisis, regulation has meant that banks are often required to hoard dollars in order to meet capital ratio requirements. As you saw the repo problems of last year and also those tax changes which encourage U.S. corporations to repatriate some of their international dollars was another drain of dollars from that global system was helping to give a fiscal boost to the domestic U.S. economy. And peak globalization may have also been a peak in global U.S. dollar flow. The US central bank has therefore been stepping into the breach. The availability of dollars has become far more pressing than the cost of dollars and hence the ongoing injections of liquidity. And this should also be another stabilizing mechanism that might prevent the dollar from becoming a runaway train to the upside. If price implies scarcity, it will be further ammo for the central banks to come back yet again with sizable accommodation. But if the U.S. dollar continues to rise, it could reach the tipping point that leads to a rush for the currency and a disorderly move higher, which is a very threat that central banks, including the Fed, worry about most now in that scenario. Global financial conditions would tighten. Emerging market equities would fall. Commodities would fall. Inflation would fall. Growth expectations would fall. And U.S. bonds would continue to rise. And yields fall, with the spotlight firmly back on those central banks for yet more sugar. 

    [00:13:19] China continues to dominate and dwarf all of the regions in terms of the virus outbreak headlines and numbers. But the shift in focus towards Korea, Italy and Iran continues to have serious implications for global supply chains, as can be seen in the recent wobbles of some of the major exporting currencies. When we look at the updates from Tiago Teodoro of Market Psych Research showing the fear and sentiment index for China - and remember, this is based on the frequency of media stories covering the coronavirus subject - the fear index looks like it may now have peaked, while sentiment still remains in that red zone. Japan and Korea, on the other hand, look like they are still in the phase where fear is on the rise and sentiment is falling. The resurgence of negative sentiment within the Japanese press reflects the second phase of the outbreak as it shifts towards an international perspective. Weakness in the euro and the yen may be reflecting investment flows from Europe to other regions, but weakness in the Korean Won will be reflecting the real concerns for an already fragile economy, where the equity market also took a hit on Monday when this segment was filmed. Across other assets, perhaps the biggest levels to watch remain the $51 level in West Texas oil and the $250 level on Comex copper futures. These are the must hold levels we highlighted a couple of weeks ago and so far they have held. Remember, these are real world assets that are harder to manipulate compared to financial assets such as equities, where liquidity can drive performance. And if oil and commodities break down, then the Canadian dollar looks vulnerable to a break of the five year resistance level. These levels are obviously just guidelines and historical perspectives. Perhaps the cleanest place within financial assets are fixed income and gold. The US 10 year yield is still declining. About 1.3 to 1.4 percent yield region is close to the all time lows. And if this breaks, then the US 2Year/10Year segment of the yield curve should again invert. And the decline in nominal yields has again been driving the level of real yields. With a break to new lows in real yields, gold has had a new leg higher and if you have 10 year real yields now headed back to the minus 100 basis points level we highlighted a few weeks ago, then that should be a great tailwind for gold. So in summary, overall long bonds, long eurodollar futures such as the December 2021 contract, short the Korean Won, these look like good places to hedge for the ongoing spread of the outbreak. Equities may be on the move, but the big question still remains whether central banks can prop up this framework or whether this is now effectively out of their control.

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