For all those following the relentless rise in the USD and assuming this is a great thing for global markets, here is a must read take from SocGen’s Kit Juckes.
* * *
GOOD DOLLAR, BAD DOLLAR
The ECB is buying more bonds than expected, and from longer maturities. ECB President Mario Draghi was almost scornful of concerns about the lack of burden-sharing in the event of losses. Equities rallied, credit spreads tightened, and both yields and spreads fell across European government bonds. The Euro has fallen against every major currency except for the Danish Krone today and every major currency except for the Canadian dollar and Czech Koruna this year. It has further to fall, even if it is long overdue some kind of correction. The CEEFX currencies in particular are likely to see gains (PLN to the fore). But as outsized moves repeatedly surprise asset markets, there is a need for caution – A strong dollar has a Jekyll and Hyde personality – a ‘good dollar’ that reflects economic and monetary policy divergence and whose rally is orderly and limited. And a ‘bad dollar’ which de-couples from monetary policy and reflects instead a loss of investor in the face of higher volatility. That dollar rises faster, much further, and is potentially devastating.
The danger of disorderly moves
The Ruble has fallen by 50% in a year. The price of oil has halved, the price of copper, iron ore and many other commodities has tumbled. The Swiss franc has been de-floored and the uproar was huge. All random events, all part of a pattern. Financial markets are feeling the effects of a pick-up in volatility that has followed the end of Fed QE. While zero rates were augmented with Fed bond-buying, investors went around the world in search of higher yields, in all sorts or assets and currencies. Traders and investors of one kind or another resorted to leverage to reach the yield targets they needed to match their required investment returns. All of which was fine while the party went on forever, but now that it’s ending, the outcome is anything but fine.
It’s only when the tide goes back out you see who is naked, and it’s only when volatility picks up that we can start to place markets on a scale between ‘fundamentally-driven trend’ and ‘bubble’. And we have been busy learning a few home truths;
1) The commodity/resources boom, was a bubble. A lot of the increase in demand came from just one country which is bad enough but that was exacerbated by traders and investors as commodities became an ‘asset class’. We’re going to find new clearing levels (perhaps not far from here, but a lot lower than they were) for natural resources which re-balanced global wealth from developed to developing economies, and are now re-re-balancing wealth (and growth) back the other way.
2) USD 100/barrel oil was also partly down to investor behaviour. We could all see the boom in alternative sources of supply and we all watched as crisis erupted in Iraq, but oil prices just didn’t get the kind of lift we were fearing a year ago. Again, I don’t pretend to know where the clearing price for oil (ie, the bottom of this move) is, but we’ll end up in a new lower range.
3) EM currencies were overvalued. I have sent out countless charts over the last 18 months of real effective exchange rates that show by just how much a range of emerging market currencies have appreciated in real terms since the last time the Fed started a rate-hiking cycle. Many of these have now corrected, savagely. Not all though – the CNY for one, stands out like a sore thumb.
4) There was more leverage in the Swiss franc short than any of us imagined. Going short Swiss francs relied on the assumption that there was no way the SNB would allow the EUR/CHF floor to break, given that they could intervene to hold the CHF down and infinitum. Clearly, a wrong assumption but the common trading/investment tactic was to see low volatility as a reason why it was OK to take large leveraged positions that made money if EUR/CHF drifted modestly higher.
On the surface, these trends are largely unrelated. But what they have in common is that leveraged trades facilitated by easy Fed policy and low volatility, have become crowded and corrected more than expected. These are certainly not the only such examples of this kind of move that we will see in 2015. The end of Fed QE is only a small move – certainly small compared to say, an actual Fed rate hike. When that happens, we’ll turn the volatility up another notch or three.
Leaving rates too low relative to the underlying growth of the economy for too long, was/is dangerous. There’s no precise science to monetary policy, but you can see the unintended consequences of rates being too low for too long in these moves. There’s a danger that from here, we see more volatility, more capital repatriation into the dollar (and perhaps, temporarily, into the yen too). If that happens in a disorderly fashion, we’ll move from a reasonably benign dollar rally, to a disorderly and dangerous one. If the dollar appreciates in line with monetary policy divergence, and reflecting relative economic performance, then we are in for a period of volatility but nothing disastrous. The Fed is not going to be able to raise rates by as much as in past cycles, starting this late in the cycle and against this backdrop. So the dollar ‘should’ rise moderately. But the omens from these recent moves are not good. The more leveraged trades are unwound and the more we see out-sized moves in commodities, and other assets, the greater the risk that we end up with a ‘bad dollar rally’ which has the same global effects as we saw in the mid/late 1990s, when emerging market economies were knocked over like dominoes as capital fled back to the US. Worse still, after another 20 years of globalisation and the idea that the developed economies could withstand a multi-year period of much higher asset market and EM economic volatility, is absurd.
The ‘bad dollar rally’ is not a central case in forecasts but the cascade of large FX moves are a sharp warning sign. But then it never is until after it has happened and it’s a big enough risk to suggest that the dollar has more upside than would be assumed by simply plugging in recent historical correlations between currency pairs and interest rate moves, either in nominal or real terms. The central case, for the global economic outlook, and for the dollar, may be for an orderly move. But the ‘tail risk’ of an outsized currency move and a worse economic outcome, is growing.
The cascade of large FX moves is accelerating, a repeat of past crisis
Periods of USD strength typically lead to a cascade of larger USD moves across crosses. The last major example was the Asian crisis in 1997 with an accelerating series of dominoes (Thailand, South Korea…). At that time, Asia was heavily linked to the USD leading it to borrow in USD but crucially hold little in FX reserves.
Sometimes large FX moves are simply a result of plain mismanagement exacerbated often enough by a degree of pegging to the USD. The latam crisis of the 1980s fits into this category with Brazil only stabilizing in the 1990s. Another example of severe economic mismanagement was the break up of the Soviet Union in 1991 leading to the emergence of multiple collapsing currencies versus the USD. The last significant wave of USD strength came with the collapse of Lehman as banks and many other actors were caught short USD and long risk often enough in EM. This trade was quickly reloaded but has started to once again collapse with BRL leading the move as it was left massively over expensive. This was just a sign that EM FX had overshot versus fair value and commodities related currencies far more so. Since then the reversal in terms of trade gains made since 2002 has sharply accelerated the number of large FX moves (BRL, Copper/China trade, Oil with RUB, NOK, CAD…).
The number of currencies with 10% moves of the last 12 months is now close to historical highs. The number of currencies collapsing by 40% is slowly growing higher as happened in previous waves of USD strength. As oil prices fall leaving system built on high prices unsustainable or extreme FX valuation create unbearable deflationary shocks, the number of large FX moves may surprise once again to the upside in a world with a dearth of safe havens. The US Treasury market, the USD and for a while the CHF are one of the few places left.