US economy

Resilient dollar must crack for risk appetite

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A new week began with fresh doubts over a trade detente, which sparked weaker equities and a drop in sovereign bond yields. The US dollar also dipped on Monday, knocked by a Donald Trump tweet that referenced currency strength during a meeting with Jay Powell of the Federal Reserve at the White House. A resilient dollar certainly irks the president, but it also highlights for equity bulls the limits for a sustainable rally in risk assets. 

A weakening US dollar is usually a sign of brimming global risk appetite and yet a definitive downturn in the reserve currency remains elusive. With the US dollar sitting near its trade-weighted highs, any validation of a global rebound over the coming months should prompt a weaker reserve currency. Also of note has been the inability of copper and other industrial metals to support equity market hopes of a cyclical-led rebound. 

Taking the dollar index as a proxy of risk appetite, with a steady decline during 2017 and into early-2018 for the DXY (weighted mainly in favour of the euro), and the Federal Reserve’s trade-weighted measure (as shown below) tells us what a global synchronised recovery has in the past entailed in the currency space. For multinational companies in the S&P 500, a weaker dollar is part of any 2020 earnings growth recovery. 

At the moment, currency markets are awaiting details of any trade deal between the US and China and, more importantly, whether equities have over-egged expectations of a forthcoming bounce in global activity.

Katie Nixon at Northern Trust makes the following point about a trade deal:

“The most important outcome, from a market and economic perspective for both countries, is to avoid the imposition of the December tariffs that are aimed directly at the consumer — the single area of strength. Avoiding these tariffs will be important.”

In currency-price action terms, China’s renminbi has been unable to sustain a rally through Rmb7 per dollar. That shows how a trade deal is required to convince buyers of a sustained rise. In turn, emerging market currencies have eased back from their October rally, leaving the MSCI EM FX index just above its 200-day moving average, a test of near-term sentiment.

The euro for now is holding above $1.10, suggesting a possible bottom in place. One trade-sensitive currency, the Australian dollar, has also shown signs of stabilising, but a drive back towards 69 cents (a brief peak earlier this month) is required to keep the faith in the near term. Trade progress is seen helping the Korean won, Taiwan dollar and Singapore dollar, or at least easing the pressure from short sellers.

Hardly helping clarify matters is the extent of any forthcoming bounce in economic activity. Not only did China ease policy on Monday (See Quick Hits), the latest trade data from Singapore showed a modest improvement although it fell short of expectations.

Weakening growth is not just confined to Asia, as many are highlighting a tough fourth quarter for the US economy. It’s still comparatively early going, but the Atlanta Fed’s GDPNow model currently places fourth-quarter GDP growth at 0.3 per cent (down from 1 per cent a week ago). The New York Fed’s Nowcast model plots Q4 growth at 0.4 per cent, a drop from a prior weekly forecast of 0.73 per cent.

This trend has the potential to sap the dollar from here as it would raise the prospect of further Fed easing early next year. But in a world of pervasive central bank easing, there’s a strong argument that a fed funds rate falling below 1 per cent in 2020 is what ends the US dollar’s eminence.

Alan Ruskin at Deutsche Bank says that should markets start “thinking that the funds rate cycle ends at zero — rather than an unlikely terminal rate at 1.25% that is currently priced in” such a development “could create a clearer USD top, and a more decisive trend to trade”. 

Indeed, for all the Fed’s recent easing efforts, notably renewing the expansion of its balance sheet, the global financial system still needs plenty of dollars and such demand potentially limits a sustained rally in risk appetite, particularly for EMs. 

A weekend update from the Institute of International Finance notes: 

“One of the important drivers of dollar appreciation has been strong overseas demand for USD funding in capital markets.” 

The IIF also illustrates via this chart how within EM economies “US dollar-denominated debt has increased from $2.8 trillion in 2009 to over $6.1 trillion in mid-2019”. 

Within the EM share, IIF notes: 

“Non-financial corporates (USD debt has more than doubled since 2009, to $2.9 trillion) and the EM financial sector (USD debt up by $1.4 trillion to $2.3 trillion).”

Another source of robust demand for dollars that works against a substantially weaker reserve currency is the role played by non-US financial institutions. The IIF notes that the dollar liabilities of Japanese, Chinese and Canadian banks “have risen from below $10 trillion in 2009 to over $13.5 trillion at present”.

Progress on trade is the biggest driver across global markets at the moment and one that many think favours buying Asia and other select areas of EMs in 2020. But that shift requires a sustained weakening tone for the US dollar. Fed policy looms large here and perhaps sooner than some think.

As Didier Saint-Georges, managing director at Carmignac, writes:

“The US financial system is now faced with a USD liquidity issue for which the Fed has found no lasting solution yet. This puts a myriad of small highly-leveraged US financial players at risk. Incidentally, it also prevents the USD from weakening from its overvalued level. The USD 60bn monthly liquidity injection decided last month by the Fed is visibly not enough to fix the problem. More will need to be done, and rapidly, in order to avoid a liquidity accident.”

Quick Hits — What’s on the markets radar

A rate cut by the People’s Bank of China signals more easing ahead as Beijing tries to bolster the economy and also avoid any liquidity issues as year-end approaches. The PBoC cut the seven-day reverse repurchase rate to 2.50 per cent from 2.55 per cent, the first easing since October of 2015. In turn, China’s 10-year yield edged to 3.2 per cent, its lowest level in a month, while the equity market bounced, paring back some of last week’s 2.4 per cent decline. 

Economists at Citigroup expect a measured pace of rate cuts from the PBoC. They “see a higher likelihood of a RRR cut of 50bps in early Jan 2020”. But the bank does caution:

“The possibility of a targeted RRR cut to boost bank lending to manufacturing sector, especially the hi-tech sector in Q4, can’t be excluded either.”

Sterling has a patchy record on gauging election and referendum outcomes, but at the moment the currency market likes current polls that indicate a widening lead for the Conservatives over Labour. Here’s a link to the FT’s poll tracker

The pound is just shy of $1.30 versus the dollar. Brown Brothers Harriman says a break beyond the October 21 high near $1.3015 “would set up a test of the May high near $1.3185”. Against the euro, sterling has rallied to a six-month high, with the 85 pence-per-euro level in sight. In 2016 and 2017, the pound’s rebounds subsequently faltered around the 84 pence area. 

All up, the pound looks near a top until the general election result provides the next catalyst for the currency market.

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