Special Report
Highlights Currency markets continue to fight a tug-of-war between deteriorating global growth and easing global financial conditions. Meanwhile, history suggests that the trade-weighted dollar should have been 10-15% higher, based on portfolio flows and interest rate differentials. The more-muted bounce is a cause for concern. As the battle unfolds, likely winners in the interim will be safe-haven currencies such as the yen. Watch the gold-to-bond ratio for cues on where the balance of forces are shifting, with a rising ratio negative for the dollar. We expect a day of reckoning to eventually arrive for the U.S. dollar, once investors shift their focus towards the rising twin deficits, de-dollarization of the global economy and low expected returns for U.S. assets. Feature The recent calm in developed currency markets seems very eerie, given the storm that has gripped global financial markets over the past week. Dismal manufacturing PMI readings from Europe and Japan last week sent equity markets into a tailspin. The closely watched U.S. 10-year versus 3-month spread inverted, triggering panic selling among investors who favor this spread as their most reliable recession indicator. Equity markets in Asia are off the year’s highs, while regional bond yields are holding close to trading lows. Outside of oil, commodity markets have also been soft. Despite these moves, the trade-weighted dollar has been relatively stable. Over the last few months, most currency pairs have been narrowly trading towards the apex of very tight wedge formations. This has severely dampened volatility (Chart 1). Over the longer term, the stability of these crosses relative to gold has spooky echoes of a fixed exchange rate regime a la Bretton Woods (Chart 2). Chart 1An Eerie Calm In Currency Markets Chart 2Fixed Exchange Rates Versus Gold? In physics, centripetal systems tend to stay in equilibrium, while centrifugal forces can explode in spectacular fashion. In the post-Bretton Woods world, it has been very rare for periods of extended currency stability to persist. This means constantly monitoring both the trend and magnitude of imbalances between economies to gauge where the pressure points are, and in what direction the corresponding exchange rates might eventually give way. The balance of forces driving the dollar outlook seems like a natural starting point for this exercise. Global Liquidity And The Dollar Judging by most measures of relative trends, the dollar should be soaring right now. The March Markit manufacturing PMI releases last week showed that while both Japan and the euro area remain in contraction territory, the U.S. reading of 52.5 puts it solidly above the rest of the world. It is true that the momentum of this leadership has been rolling over recently, but historically such large growth divergences between the U.S. and the rest of the world have generated anywhere from 10-15% rallies in the greenback over a period of six months (Chart 3). So far, the DXY dollar index is up 1.9% since October. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere. Until the U.S. Federal Reserve’s recent volte-face on monetary policy, relative yields also favored the greenback. The 2-year swap differential between the U.S. and the rest of the world pinned the DXY dollar index at 105, or 8% above current levels (Chart 4). Meanwhile, relative policy rates also suggest the broad trade-weighted dollar should be 6% higher. And even today, unless the Fed moves towards outright rate cuts, the dovish shift by other central banks around the world remains an immediate tailwind for the U.S. dollar. Chart 3USD Should Be Higher Based On Growth Divergences Chart 4USD Should Be Higher Based On Swap Differentials Internationally, the Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling ever since. This has triggered a severe contraction in the U.S. monetary base (Chart 5), and severely curtailed commercial banks’ excess reserves, which are now contracting by over 20% on a year-on-year basis. One of BCA’s favorite key measures of international liquidity is foreign central bank reserves deposited at the Fed. This is contracting at its worst pace in over 40 years. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere, typically among countries running twin deficits. Chart 5A Liquidity Squeeze Of Dollars To cap it off, last year’s change in the U.S. tax code to allow for repatriation of offshore cash helped the dollar, but not to the extent that might have been expected. On a rolling 12-month basis, the U.S. has repatriated back a net of about $US400 billion in assets, or close to 2% of GDP. Historically, this is a very huge sum that would have had the potential to set the greenback on fire – circa 10% higher (Chart 6). Chart 6USD Should Be Higher On Repatriation Flows Dollar liquidity shortages tend to be vicious due to their ability to trigger negative feedback loops. As the velocity of international U.S. dollars rises, offshore dollar rates begin to rise, lifting the cost of capital for borrowing countries. Debt repayment replaces capital spending and consumption once this reaches a critical threshold. The drop in output, prices, or a combination of the two, only exacerbates the debt-deflation problem. The bottom line is that looking at historical trends, the dollar should be much higher than current levels. Practical investors recognize the need to pay heed to correlation shifts. Either our favorite liquidity indicators have stopped working outright or more realistically other forces are at play, explaining the relative stability in the greenback. A Counter-Cyclical Currency The first possibility is that the recent stability in the U.S. dollar has been in anticipation of better economic data in the second half of this year. We have shown many times in the past that the greenback is a countercyclical currency that tends to do poorly when global economic momentum picks up. Many investors are now fixated on China – specifically, whether the latest credit injection will be sufficient to turn around the Chinese economy, let alone the rest of the world. Meanwhile, as the U.S.-China trade talks progress, it will likely include a currency clause to prevent depreciation of the RMB versus the dollar. In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability. In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability. Typical reflation indicators such as commodity prices, emerging market currencies and industrial share prices are off their lows but rolling over. March export data remained weak globally, even though compositionally there were some green shoots. Exports to China from Singapore jumped by 34% year-on-year, and those to emerging markets by 22% year-on-year. Japanese machine tool orders from China also showed some stabilization. Historically, these are necessary but not sufficient conditions to gauge whether we are entering a bottoming process (Chart 7). Another contradiction is at play: If the dollar rally is being held back by prospects of improvement in global growth, then gold should fare poorly and most currencies should be outperforming both gold and the greenback. Until yesterday’s sell off in gold, this was not the case. Suggesting some other explanation might be tempering the U.S. dollar’s rise. Chart 7Tentative Green Shoots In Global Trade? Regime Shift? While U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. capital markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners, the largest on record (Chart 8). In aggregate, both foreign official and private long-term portfolio investment into the U.S. has been rolling over, with investor interest limited only to agency and corporate bonds. Foreigners are still net buyers of about $450 billion in U.S. securities, but the downtrend in purchases in recent years is evident. Interestingly, gold has also outperformed Treasurys over this period. The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges. Vis-à-vis official flows, China has risen within the ranks to be the number one contributor to the U.S. trade deficit. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB (Chart 9). In a broader sense, the fall in dollar deposits at the Fed might just represent an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Chart 8Foreigners Are Dumping U.S. Equities Chart 9China Has Stopped Recycling Surpluses Into Treasurys Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. Meanwhile, allocation to other currencies, notably the British pound, Swiss franc and the yen have been surging (Chart 10). At the same time, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart 11). This further helps explain why the dollar may not be as strong as it should be. It also explains the stability of these currency pairs relative to the price of gold. Chart 10The World Is Diversifying Away From Dollars Chart 11Central Banks Are Absorbing Most Gold Production The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will swell to 4.5% of GDP. Assuming the current account deficit widens a bit then stabilizes, this will pin the twin deficits at 8.1% of GDP. This assumes no recession, which would have the potential to swell the deficit even further (Chart 12). Chart 12A Twin Deficit Cliff For The Dollar The U.S. saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the U.S. trade deficit. Shale productivity remains robust and U.S. output will continue to rise, but the low-hanging fruit has already been plucked. For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising U.S. twin deficits, this will continue as well. And if the U.S. dollar cannot sufficiently rally on “good news,” expect it to sink when the bad news eventually starts rolling in. That said, the timing remains uncertain. Private Capital Flows Foreign official flows might have been fleeing the U.S. dollar because it has lost some luster as a reserve currency, but private capital will begin stampeding toward the exits when the return on invested capital (ROIC) for U.S. assets falls below their cost of capital. For investors with a long horizon, this may already be happening. Take 10-year government bonds for example. For the Japanese or German investor, borrowing in local currency and investing in the U.S. might seem like the logical course of action given negative domestic rates and a 10-year Treasury yield of 2.4%. However, this positive carry suddenly evaporates when one factors in hedging costs (Chart 13). Chart 13JGBs More Attractive Than Hedged Treasuries During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows. With many yield curves around the world inverting, the danger is that the frequency of this short-covering implicitly rises, since long-bond returns are falling short of spot rates. One winner as volatility starts to rise is the yen. Investors should consider initiating short USD/JPY positions today as a hedge. Outside the fixed-income space, what matters is that relative ROICs are higher than the cost of capital. Both are difficult to measure for many emerging or even developed economies across asset classes. However, for the equity market, a good starting point has always been valuations as exchange rates tend to move to equalize returns across countries. The forward P/E on the MSCI U.S., Europe and Japan indexes is 16.5x, 12.6x and 12.3x. The skew towards the U.S. is because market participants expect U.S. profits to keep outperforming, the U.S. currency to keep appreciating, or a combination of the two. However, empirically, current U.S. valuations suggest future earning streams have already been fully capitalized today (Chart 14). Chart 14AReturn On Capital Could Be Lowest In The U.S. (1) Chart 14BReturn On Capital Could Be Lowest In The U.S. (2) Chart 14CReturn On Capital Could Be Lowest In The U.S. (3) The expected 10-year annualized return for MSCI U.S. is 3.1%, versus 5.5% for MSCI Europe and 9.6% for MSCI Japan. If we assume the U.S. dollar is overvalued, as some models suggest, this will further erode future U.S. returns. Net equity portfolio flows into the U.S. are already negative, as shown in a previous chart. This means the day of reckoning for the U.S. dollar may not be far off when current tailwinds eventually fade. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
