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The US Dollar Breaks Out

Currencies | Aug 21 2014

By Louis Gave of GavekalDragonomics

Is there a more consensus trade then being bullish on the US dollar? With a) the US economy outperforming those of Europe and Japan, with b) the Federal Reserve looking to withdraw some of the extra-ordinary stimulus that it has deployed in the past five years, just as the need for the European Central Bank, and possibly the Bank of Japan, to become a lot more aggressive becomes ever starker, with c) the Pentagon limiting its defense spending and its costly military involvements around the world… being bullish on the US dollar makes sense. And there are many more arguments one can make in hitching one’s wagon to the dollar.

In recent years, we have argued that the ability of the US to produce ever more of its energy at home would lead to a structural improvement in the US trade deficit, which in turn could lead to shortages of US dollars abroad and that US dollars would be needed to fund the expanding intra-emerging market expansion in trade. We have also argued at length that the rapid progress in robotics and automation would accelerate the onshoring of large tracts of US production, thereby further improving the US current account deficit. All these arguments are, by now, well worn. But does that mean that they are reflected in US dollar valuations?

We do not think so. In fact, a quick glance at the DXY index highlights that, for all the market’s positive chatter surrounding the dollar, the unit really has done very little over the past few years. As things stand, we are basically trading roughly at the same levels that have prevailed for most of the post-2008 crisis period.

In fact, one surprising development in recent months has been how quiet foreign exchange markets have been in the face of unforeseen developments: from the war in Gaza, to the shooting down of the Malaysian airlines plane by pro-Russian goons, to the bad data coming out of the eurozone, Japan and the Chinese real estate market, to the Banco Espirito Santo effective failure and the Islamic State victories in Iraq, this summer has not lacked for dramatic news stories. Yet, as far as the foreign exchange markets are concerned, it’s all been like economic sanctions off Putin’s back. But could this be about to change?

The past 48 hours have been interesting in that we have witnessed bond markets rally in Europe and sell off marginally almost everywhere else (reflecting the different outlooks for growth across the different zones). At the same time, the US dollar seems to be breaking out against the euro and the yen while commodity prices (most notably oil) appear to be breaking down. All this begs the question as to whether the largely consensus bullish US dollar trade is about to finally pay off? And, if so, what does it mean for portfolios?

The first and most obvious conclusion is that a strong dollar, combined with lower commodity prices, will help keep US inflation in check; thereby ensuring that any tightening the Fed embarks on in 2015 remains modest. At the same time, a fairly cautious Fed, combined with a stronger US dollar and tame inflation, will mean that any asset which generates steady dollar, or quasi dollar, cash-flows (whether US corporate bonds, high dividend yielding stocks, US real estate, Hong Kong utilities…) will remain well bid.

The second is that owning bonds in a non-US dollar currency to hedge away equity risk is rapidly becoming less attractive. Indeed, why own 10 year bunds yielding 1%, or JGBs yielding 0.5% in falling currencies when you can own 10-year treasuries denominated in a rising dollar yielding 2.5%? A rule of thumb we like to follow is to either own high-yielding bonds in a potentially weak currency (i.e., Indonesian rupiah bonds, Philippine peso bonds, Brazilian real bonds, Greek bonds) or to own low-yielding bonds in a country with a potentially stronger currency (i.e., Hong Kong dollar bonds, Singapore dollar bonds, renminbi bonds…). But owning low-yielding bonds in falling currencies has limited appeal!

The third major question raised by a stronger US dollar is whether this will sink the nascent emerging market bull market. After all, in the past, dollar strength usually triggered emerging market underperformance (as US dollar loans all of a sudden became more expensive to service, and as high net worth individuals in emerging economies have transferred savings from domestic currencies to the dollar). We do not think so, for several reasons, including the fact that a) the rise in the US dollar appears to be very gradual and thus minimally disruptive for most emerging economies, b) emerging markets have, since 2008, learnt to reduce their dependency on the dollar and use other currencies (most notably the renminbi, but also the euro) to settle intra-EM trade, c) few emerging economies are today running large current account deficits; as such, funding crises appear unlikely, d) for commodity consuming emerging economies, the fall in oil (and iron-ore, and shipping rates, and copper…) will help cushion the rise in the dollar.

In conclusion, we continue to believe that we are moving into a ‘strong US dollar world’. This makes for a very different set of winners and losers, and very different portfolios, than what most investors have been used to over the past decade or so. If nothing else, it makes underweighting the US in any portfolio a risky proposition. And, in our low yield world, the changes in currencies could well end up driving the performance for most fixed income portfolios.

Reprinted with permission of the publisher. Content included in this article is not by association the view of FNArena (see our disclaimer).
 

The information contained herein is provided for informational purposes only and should not be regarded as an offer to sell or a solicitation of an offer to buy the securities or products mentioned. This document is a private publication intended for private distribution. The value of all investments and any income generated can decrease as well as increase. Performance numbers shown are records of past performance and as such do not guarantee future performance. No representation is made that any one investor achieved any of the results shown herein. This information is subject to change without notice. The securities and products mentioned may not be eligible for sale in some states or countries, nor suitable for all types of investors. Gavekal Research Limited does not warrant the accuracy, completeness, reliability, fitness for a particular purpose or merchantability of this information, and expressly disclaim liability for errors or omissions in this information and data. Gavekal Research Limited shall have no liability for the use, misuse, or distribution of this information to unauthorized recipients.

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