Which of these two stories or narratives sounds most convincing to you?
In narrative A, the global economy is strong, the recovery is picking up speed in most regions whilst the US powers ahead helped along by tax cuts. In this telling, global stockmarkets are strong because of booming corporate cash flows. As a result, investors worry a bit about inflation and rather more about increasing rates but the overall tone is bullish. All the political talk about trade wars is just that – talk. Trump wants to get re-elected and he won’t spark a real showdown.
In narrative B, the US is late in its business cycle, whilst the rest of the global economy looks like it’s about to slip back into a recession helped along by rapidly increasing interest rates and galloping inflation. Surging oil prices will crush consumer demand and China is struggling with unbalanced growth and too much debt. Oh, and whilst we’re on the subject of China, trade barriers are popping up everywhere and we’re one step away from a trade war. US bond yields are only bobbing around 3% because there are so many buyers of US Treasuries, bidding up purchase prices and helping to keep the yield on 10 year Treasuries down around 3%.
Which narrative you – and the wider markets – choose matters hugely if only because of the recent strength of the dollar. Many strategists and analysts would have you believe that this recent strength in the dollar is pretty much exclusively the result of rising US interest rates. In this worldview, the US dollar is attractive in a world of low-interest rates because the US Fed is aggressively, and steadily increasing interest rates. Thus, institutional clients are selling down their holdings of low yielding Euros, yen and sterling to buy higher rating US bonds and paper.
I find this explanation highly unlikely as the primary driver of FX markets. I can’t imagine that there are that many big institutions who will decide to sell a mountain of euro bonds for US bonds based on an uplift of say 0.50% or 50 basis points from US Treasuries, especially when they factor in the very real FX risks. Demand for currencies is determined by a great many factors, many of them trade-related – my hunch is that interest rate differentials are one of the lesser factors influencing FX rates in the short to medium term.
FX rates are determined by more ‘base’, structural factors – with my two earlier narratives representing two contrasting worldviews. In the first narrative – the optimistic one – the dollar should WEAKEN from here on in, largely because investors and traders will be expecting a more diversified set of outcomes which would favour currencies other than the dollar.
In the second narrative – the more pessimistic one – we are one step away from a real slowdown and the dollar is attractive because it is a safe haven currency i.e a hedge or insurance policy against bad things happening. In this scenario, we should expect the dollar to STRENGHTEN …as it has done recently.
As my old economics tutor used to tell me, ‘follow the facts young man’. In very simple terms, I would argue that the recent strength in the dollar is telling us that something wicked this way comes i.e we’re heading towards a slowdown.
Investors, corporates, sovereigns and traders are starting to bet on the worse outcome and the dollar is a safe place to hide. This argument is certainly backed up data coming out of the hedge fund community. European asset management group Lyxor recently examined these active traders’ portfolios and found that that both CTAs and Macro funds have gone long the dollar in a major way.
According to Lyxor trend following hedgies, called CTAs, turned net long U.S. dollar mid-April. By contrast, these actively managed funds are now net short the CHF, AUD and CAD. Big macro funds have also moved into a conviction trade that is net long the dollar, according to Lyxor.
Are the hedge funds betting big on a slowdown? The data suggests they are !
Arguably one could argue that this is a form of cognitive dissonance – traders and investors are latching on to the wrong sets of statistics. Most other measures used by investors tell us that the global economy is actually doing just fine.
Inflation though increasing is under control. Corporate cashflows are surging and equity markets are at peak valuations. China is picking up speed and the emerging markets are in good shape. Either these facts are an illusion or the US stock market for one is telling us that the dollar is overvalued. And in truth there are lots of good reasons to argue that the dollar is overvalued. Here’s five for starters:
- Trump tariff effect – US President Donald Trump’s announcement of the introduction of import taxes on steel and aluminium only adds to driving down the greenback.
- Cost of hedging – Hedging US dollar risk has increased meaningfully since the last quarter of 2017, which makes investments in US treasuries by European or Japanese investors costly.
- US equities are over valued – many investors are taking profits on their US equities, selling the dollar and reinvesting back into ‘cheaper’ European and Japanese stocks
- Increasing fiscal deficit – US tax reform indicates an increase of fiscal deficits, which historically has tended to weaken the dollar.
- China is starting to reduce treasury exposure to the dollar – China is not allowing the value of the renminbi to fall, as Beijing worries about being accused of currency manipulation. At the same time, the People’s Bank of China is not buying as many US treasuries as it usually does.
So, back to my question at the beginning.
Which narrative do you buy into?
If it’s narrative A, you should be a contrarian, and net short the dollar – and stick with your risky investments such as equities. Gold in this scenario looks vulnerable.
If, on the other hand, you buy into narrative B, you should do the exact reverse. Sell those equities, buy the dollar and sit tight for the coming storm. The strengthening dollar won’t help gold at first but once the smell of fear becomes heavy, gold prices might start to move ahead sharply.
Whatever narrative you pick, I’d suggest keeping a beady eye on the dollar. The greenback is still the best canary in the gold mine, warning us of trouble ahead.