King Dollar Has “Unfinished Business”

This week was about one thing, and one thing only: uber hawkishness from the Fed.

To be sure, “uber hawkishness” means something entirely different today than it meant in the Volcker years. Now, you’re a hawk if you think the Fed Funds should be 75 bps.

Still, it’s all relative. We live in a world where negative rates are becoming the norm rather than the exception for developed market central banks. Hawks aren’t what they used to be.

In a sign of the times, the market-implied odds of inflation surpassing 3% in the US any time in the next 10 years have fallen to just 7%. The number was nearly 50% three years ago.

(Chart: Goldman)

The problem for Janet Yellen and the FOMC is that they are trying to normalize policy in an increasingly interconnected system at a time when everyone else is still easing. That effort is complicated immeasurably by the fact that the dollar is the reserve currency. At a time when the euro and the yen are trading under a NIRP regime (not to mention increasingly expansive QE programs) and emerging markets are perhaps more vulnerable than ever to USD strength, any move by the Fed - no matter how inconsequential from a historical perspective - will reverberate throughout the global financial system.

The implications for today’s markets are clear: 1) the Chinese would need to figure out how to cope with the fact that the currency to which the yuan is pegged is soaring (and that’s complicated by Beijing’s desire to drive the RMB lower against the trade-weighted basket adopted in December); 2) emerging markets and especially EM commodity exporters would need to ready themselves for outflows and further FX pressure; 3) the market would need to prepare for renewed pressure on crude. All of that points to volatility.

Seen in that light, it’s somewhat surprising that the Fed picked last week to lean hawkish and convey their desire to hike next month. Frankly, it speaks to the idea that the FOMC has no idea how to communicate effectively with the market. You’ve already waited this long and you punted in March, why not just wait until September after the British referendum and after Kuroda and Draghi have another chance to ease?

Whatever the case, what’s done is done and the question now is whether the USD has further to run. For Goldman, the answer is yes. As it turns out, Deutsche Bank agrees. In their latest “FX Blueprint”, the German behemoth (which may or may not turn out to be the next Lehman) makes a convincing case for USD upside. “we still see the Fed as an important market driver and do not believe the dollar up-cycle is over,” the bank writes.

First, Deutsche notes that the depth and length of the dollar correction is for all intents and purposes unprecedented:

“At around 8% the size of the dollar’s correction is the third largest in history compared to other dollar uptrends,” Deutsche notes, adding that “the calendar length of the correction is approaching a record too.”

Perhaps more interestingly, Deutsche looks at the USD relative to EM currencies that matter for US trade. On that measure the USD rally looks to have legs. Here’s DB:

“The Federal Reserve’s Other Important Trading Partners (OITP) dollar is a trade-weighted index that only includes EM currencies with a significant trade share with the US. The real (inflation adjusted) OITP stands close to its 15-year average compared to a 15% over-valuation for the broad-trade weighted dollar. This points to America’s EM, not DM trading partners as still substantially lagging the FX adjustment. The last three dollar cycles have seen the OITP dollar over and undershoot fair value by more than 10% suggesting there is plenty more upside in the dollar here.”

Notably, that’s consistent with Goldman’s contention that the dollar has 15% upside from current levels. Deutsche continues:

“EM-US data surprises are currently running at the positive end of the range that has prevailed over the last few years suggesting that the risks are skewed towards renewed EM versus US disappointment. More importantly however, the massive rise in EM inflows seen in recent months is pointing to significant upside risks to the dollar in coming months. Flows are historically a contrarian indicator.”

The bank’s takeaway: “We do not believe the medium-term dollar up-cycle is over and it is likely the recent correction in the USD is complete.”

If you buy Deutsche’s analysis, there’s likely to be pain ahead for EM FX. And as I noted on Friday, EM FX is highly correlated with EM equities.
As always: trade accordingly.

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