Currencies

Investors have given up on European assets, which now suffer exceptional discounts to US ones. However, tighter US fiscal policy, the end of Europe’s austerity and deleveraging, the LNG Tsunami about to hit European shores, and the global capex fueled by the Impossible Geopolitical Trinity mean that Europe’s time to shine will soon come back.

This week we conduct a thorough audit of our open positions by revisiting the original basis and subsequent performance of all 13 cyclical recommendations. Following the review, we recommend closing 6 of the 13 positions.

European assets and the euro have become oversold and are likely to rebound. Will this move be nothing more than a dead cat bounce leading to more weakness? 

Executive Summary Political Uncertainty And The Dollar Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar The consensus is that Republicans will blow out the budget deficit, leading to a higher fiscal risk premium on the dollar. That seems unlikely for now. If the deficit does not blow out, that path of least resistance for the dollar remains up, for now. The US economy is already outperforming the rest of the world, so does not need outsized tax cuts to keep the economy humming. Longer term, what matters are expected rates of return, and the US stock market will likely see outflows in the coming years. However, the bond market matters more for currencies, and real yields remain elevated in the US.  Short-term investors should remain long the greenback. Longer-term investors should start bottom-fishing opportunities in non-currency adjusted terms where valuations are becoming very compelling. Bottom Line: Stay long the US dollar. Feature The standard economic theory is that Republicans will blow out the budget deficit, so that should be negative for the dollar, as it pushes up inflation expectations and depresses real interest rates. This is also true given a campaign trail of deregulation, tax cuts and siphoning off US competitors, via tariffs, which all sound inflationary. So far, Republicans have been rather budget friendly. For example, one of the most contested issues amongst Democrats and Republican has been what should be done around social security and Republicans are giving in to social security cuts (Chart 1). While too early to tell, the budget deficit is unlikely to be much wider under a Trump administration. Chart 1What Rising Budget Deficit? Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar Deficits And Risk Premia Chart 2Deficits And Risk Premia Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar Bond volatility has tended to rise as risks of a rising fiscal deficit increase. We might well end up in world where the US budget deficit does blow out, and investors will require a bigger risk premium to hold US bonds or the dollar. We are not there yet. It is true that the rise in the VIX and corporate bond spreads could be attributed to concerns about a widening deficit in the US (Chart 2), but a strong dollar tells us those concerns are premature for now. Putting President elect Donald Trump’s policies into perspective, the effective corporate tax rate in the US will be in line with many other countries (Chart 3). This means the prospect of an administration that fans the US inflationary wave is plausible, but not probable for now. That should keep US real interest rates high for now. Chart 3No Outsized Tax Cuts In The US Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar Putting everything together, the US runs a fiscal deficit of around 8% of GDP, while the unemployment rate only sits around 4.1% (Chart 4). Ergo, this is not an economy that needs more fiscal stimulus. Most economists on the Trump administration will consider this point. Chart 4The US Does Not Need More Fiscal Stimulus Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar The External Balance The exorbitant privilege of the dollar has meant that the US has earned more on its assets, than it has paid on its liabilities. That remains the case today, suggesting that the short-term outlook for the greenback remains positive from the basis of the US external balance (Chart 5). Ergo, more inflows into the US. That said, this is one area we are very concerned about when it comes to the dollar. For one, we know that payments on US liabilities are rising and will especially explode if we have a fiscal crisis in the US. This is worth monitoring. For now, real interest rates in the US are very positive suggesting that there should be little appetite for a massive capital flight from US Treasury securities (Chart 6). Chart 5The US External Balance Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar Chart 6Real Interest Rates And The Dollar Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar Chart 7Prospective Equity Returns Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar Another source of risk is also the US equity market. US stocks are overbought and over owned, and a massive outflow from this market is a source of risk for the dollar. Over a five-to-ten-year horizon, valuations are a perfect guide for what happens in both equity, fixed income and currency markets. The message from our valuation models is that US securities are overvalued, and we should be using dollar strength to diversify into cheaper markets like Japan (Chart 7). The bottom line is that the US market remains defensive and will likely attract inflows in a global market selloff. US bonds are also a high-yielding vehicle for many foreign investors. That is bullish the dollar. Longer-term, these factors will be outweighed by valuation concerns and rising opportunities in other markets. What Should Investors Do? Here is what we know. When global policy uncertainty is rising, especially vis-à-vis the US, American stocks perform better and the dollar soars (Chart 8). With a Trump presidency baked in the cake, the potential source of any uncertainty could come from outside the US. This will keep the dollar bid. Carry trades have been a big trend in currency markets, and with EM volatility rising, a lot of these trades could still be unwound (Chart 9). EM currencies typically have a higher carry, and the yen was the perfect vehicle to fund these trades. That said, these have blown up. Within the rubble, some interesting opportunities like the Mexican Peso and the Norwegian krone that are no longer market darlings, are emerging. Stay tuned. Chart 8Political Uncertainty And The Dollar Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar Chart 9Rising Risks In EM Currencies Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar Chart 10Our Trading Model Is Short The USD Too Soon To Book Profits On The Dollar Too Soon To Book Profits On The Dollar A final note on our US dollar trading model – it remains short the greenback. The model has underperformed our recommendations since August but keeps us grounded in the methodology we use to analyze FX markets. We are excited about a new version of this model, that is more tactical in nature. That said, the blueprint of the original model was capital preservation which will remain an important tenet of any changes (Chart 10). Chester Ntonifor Foreign Exchange/ Global Fixed Income Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Investors are overstating the positive fiscal impact of the Trump presidency. The bond market will have something to say about the scope for further deficit expansion via tax cuts. As such, the trade after the trade of the Trump 2.0 administration may involve less growth out of the US, not more. In the interim, however, investors should continue to expect higher yields and increased equity volatility. There are plenty of risks ahead, including geopolitics, trade, and uncertainty surrounding fiscal policy.

Ultimately, 2024 is not 2016 — a seemingly obvious point, but one with market relevance. In 2016, voters gave Trump a strong mandate for nominal GDP growth. It is not clear if this is the case today. Inflation is the most important issue, least relevant is trade and globalization. As such, Trump’s renewed mandate is for supply side reforms, not more populism and protectionism.

This week, we update our Central Bank Monitors (CBMs), that help us calibrate how monetary policy should be adjusted in developed-market economies. Our conclusion is that while overall, easier monetary settings are required, there a few trade ideas that arise from the divergences in signals amongst G10 countries.