With stocks the biggest beneficiary of the late January "Shanghai Accord" (that shall not be named), it stands to reason that the US Dollar was the biggest loser. Sure enough, overnight the WSJ writes that the "powerful rallies that have lifted stocks, crude oil and emerging markets for the past three months have one important thing in common - the falling dollar - and investors are growing anxious that it could prove to be the weak link."
But is a strong dollar about to make another appearance and unleash the next leg lower in risk assets?
While the dollar is down 4.5% this year and near a one-year low against a basket of currencies, other investments have surged. U.S. crude prices are up 69% from their February lows. Gold was up 16.5% in the first quarter, its best in three decades. And emerging-market stocks, bonds and currencies have enjoyed double-digit gains in 2016.
Morgan Stanley analysts quantified the relationship, and found that the correlation between a weak dollar and their own index of investor appetite for riskier assets is near its highest level in 20 years. As the WSJ writes, "the concern is that it is a relationship that could easily go in the opposite direction."
The dollar is heavily dependent on perceptions of what the Federal Reserve will do with interest rates, and those perceptions could change quickly. Meanwhile, analysts warn that the fundamentals for oil, emerging-market assets and even many stocks look too weak to support the recent price gains on their own.
"Currency is the most influential factor for markets this year," said Graham Secker, head of European equity strategy at Morgan Stanley. "If the dollar starts moving higher, global risk appetite will fall."
But just when you think the dollar tide is about to turn, you get such ugly US macroeconomic update as Friday's payrolls report, and suddenly it feels like the USD has much more room to fall (and, in tried and true centrally-planned fashion, the worse the data, the higher stocks could rally).
To be sure, conventional wisdom and positioning agrees with a "lower dollar for longer" thesis: hedge funds and other speculative investors are now more bearish on the dollar than at any other time since February 2013, according to CFTC data.
However, that bearish positioning also means any sign the Fed is turning more hawkish could send investors scampering to buy dollars, pushing the U.S. currency sharply higher.
"The market has become complacent," said Steven Englander, head of G-10 FX strategy at Citigroup Inc. "There's the risk...the Fed gives a sudden indication that really surprises the market."
The biggest risk, of course, is that Goldman will remain bullish on the USD as it has for the past 5 months, leading to thousands of pips in P&L pain for Goldman FX clients.
But maybe not even Goldman flip-flopping will be necessary for the USD to make a U-turn.
Here is another report, courtesy of Morgan Stanley's Hans Redeker, head of global FX, who believes that another round strength for the USD is "inevitable." Here's why:
Inevitable USD Strength
The USD bull market has paused for now but diverging global output gaps keep us confident that USD will resume its bull trend later this year, with the Fed raising rates in December and China’s cyclical recovery losing momentum. Currencies work as the great equaliser within open capital account economies, bringing diverging output gaps back into line. Here the work a higher USD needs to achieve is not yet complete. This week we marked-to-market our USD forecast, delaying the next appreciation phase.
Global imbalances have stayed strong but these imbalances are no longer expressed by current account differences and worries concerning foreign funding needs. Instead, current account differentials have developed into output gap differentials. Concretely, Asia’s current account surpluses have converged into supply, which within a world of demand deficiency has created overcapacity and falling investment returns.
Theoretically, there are three possible outcomes to deal with overcapacity. Austrian School-like destruction, increasing exports and finally providing debt-funded domestic demand. Creative destruction, once the backbone of a functioning capitalist system, is no longer seriously considered as the social costs of this approach appear unacceptably high. What remains are adjustments via exports and increasing local demand against ever-rising balance sheets.
Last autumn, China’s stakeholding economic model had opted for a debt-funded domestic demand push and increasing exports funded by falling export profit margins and the lower RMB. On a trade-weighted basis, CNY has fallen 4.6% since November and declining investment efficiency has undermined corporate profits. Debt continues to increase, reaching 260% of GDP, which is high for a middle income economy. Work from Reinhart and Rogoff further deepened by the BIS describes how debt reduces the credit multiplier and the potential of economies to grow.
These findings are important for FX investors. It has been China’s currently strong, but debt-funded, cyclical rebound in conjunction with the Fed broadening its reaction function pushing USD well off its January peak. USD measured by the Fed’s broad USD index has lost 6.4% since then and may fall further in the near term as investors monetise the EM risk premium. The Fed’s broadened reaction function, emphasising often globally determined financial conditions, has internationalised the Fed’s global reach, supporting EM investor confidence.
Importantly, China’s credit-fuelled demand push has propelled commodity prices and has converged global inflation rates somewhat, which has been a plus for the EM and commodity FX bloc. With an equivalent of US$9.9 trillion of DM sovereign bonds negatively yielding, demand for positively returning carry products is high. The ECB and the BoJ are seeing limitations within their remaining monetary toolboxes pushing their currencies lower, which has been an additional factor reducing USD demand.
Going forward, FX markets will have to deal with two questions in determining how long USD can stay offered. First, for how long will the Fed’s more international approach stay in place, and second, for how long will China’s economy surprise positively? At first glance, it appears as if the two questions are independent from each other. However, global output gap divergence results in diverging global inflation rates, suggesting central banks diverging and not converging policies. The Fed may increase rates only slowly, but other monetary authorities dealing with the deflationary characteristics of overcapacity and debt overhangs may have to deploy easier policies.
Tackling overcapacity via an autonomous increase in debt-funded demand may work within environments of low debt, but within high debt environments with implicitly low credit multipliers this approach only buys time. Time bought allows USD to correct lower, assets to rally and the global economy to look better. Once markets learn that diverging output gaps and hence global imbalances have not gone away, we believe that USD will rally once again. Indeed, the recent USD decline has not set the starting point of a long-term decline. Instead, we view it as a correction within a secular USD bull trend.
Who knows, maybe just once Goldman and its "strong USD" trade will, after being wrong for over 6 months, finally be right.