The dollar has been on a tear of late logging its 10th consecutive up trading day against developed world currencies through Friday's market close. Powered by rising inflation expectations and buoyed by a debt financed uptick in government spending on infrastructure by the incoming Trump administration, the dollar index (DXY) has surged to a 13-year high. Further strengthening of the dollar remains likely as recent favorable US economic and market data has placed the probability of an increase in the federal funds rate emerging out of the December FOMC meeting at near certainty, making a bullish long position on the dollar a viable market option for the near- and perhaps intermediate-term (US dollar UUP).
The euro has moved in the opposite direction, reflective of the diverging economic fortunes between the two largest markets in the developed world. The spread between the German 10-year bund and the US 10-year Treasury is 2.082 percentage points through Friday's market close--the largest spread between the two benchmarks since 1989. The dollar has logged its longest winning streak against the common currency since the latter's inception in 1999 with Friday's market close of $1.0591 - its weakest market close in almost a year-as parity again emerges as a not too distant possibility given current economic trends. The euro's slide is likely unfinished as the common currency faces an uphill battle on the political front with Italy's constitutional referendum, scheduled for the 4th of December. On the ballot is an initiative to basically do away with the upper house of the Italian parliament while awarding bonus seats to the winner of parliamentary elections, guaranteeing an absolute majority to the winning party for a five-year term. Prime Minister Matteo Renzi has mistakenly personalized the exercise by vowing to resign if the referendum goes down in defeat. Opposition parties have been handed a rare opportunity to flip the ballot question into an opportunity to oust the prime minister rather than to render a decision on his proposed reform of the famously sclerotic Italian political process. The opposition parties that dominate the "no" ranks run the gamut from the anti-establishment populist Five Star Movement headed by the Italian comic Beppe Grillo to the anti-immigrant Northern League led by Matteo Salvini both of whom have questioned Italy's continued membership in the common currency bloc. The parties are actively using the December referendum as a springboard for the coming national elections that could come much earlier than the current schedule for the spring of 2018 if a no vote is returned in December's balloting. Political uncertainty combining with another setback in the already tenuous Italian banking system that has traditionally been held in similar esteem and trust among Italians as the police and the church-continues to weigh heavily on both the Italian polity as well as the euro.
And if this is not enough downward pressure on the euro, Brexit negotiations are slated to begin in March followed by French national elections in April/May and German national elections in September. Sandwiched in between will be Austria's re-run of its May presidential election, voided due the first time out due to vote counting irregularities. The contest could see the first election of a far-right candidate since WWII, as populism continues to sweep the political landscape. The vote is too close to call. Shorting the euro presents itself as a viable market option (Market Vectors Double Short, ticker DRR).
The pound has recovered modestly from its lows of October when the currency breached $1.2164 to the dollar-its lowest post since the 1980s when Margaret Thatcher was in residence at 10 Downing Street. Yet at $1.2346 to the dollar at Friday's market close, the improvement in the pound's fortunes is marginal at best and trending downward against the relentless upward push of the dollar. Political uncertainty abounds as the May administration continues to struggle in presenting a united front in Britain's upcoming negotiations with the EU regarding the terms of Brexit. The recent unanimous High Court decision that the government gain legislative approval from parliament before invoking Article 50 of the Lisbon Treaty was a stunning blow to what little strategy the May government was been able to articulate. While the decision of the High Court will be appealed to the Supreme Court with all 11 hearing the case in December with a decision expected in January, few expect an overturn. Scotland plans to join the challenge against the May government by applying to take part in the Supreme Court hearing. A ray of hope for the government's position could materialize on the issue of whether the triggering of Article 50 irrevocably leads to Brexit, a position both sides in the High Court took as given. If the Supreme Court rules to the contrary on this narrow and arcane position, a truly pyrrhic victory for the government would result, setting up a referral to of all places-the European Court of Justice.
The pound's modicum of recovery to date is largely attributable to the High Court's inclusion of the parliament in the decision making process and will likely be short-lived. Brussels is busy drafting a UK exit document that it hopes to have in place by mid-2018. Unsurprisingly, the emphasis here is on the divorce rather than the trade side of the Brexit equation. News reports of the process have cited a UK exit cost of between €40 billion to €60 billion to cover pension, ongoing Greek loan guarantees and outstanding spending obligations on ongoing UK based projects that will need to be met-before talks turn to the future UK-EU trade relationship. News reports also underscore the EU intention that any extension of UK access to the single market be tied to an UK adherence to the four freedoms that form the foundation of the single market project which include the free movement of people, labor and capital, adherence to existing and future EU rules and the jurisdiction of the European Court of Justice-all of which are anathema to the Brexit leaders. There is plenty of further room for the pound to fall further over both the short- and medium term.
The Japanese economy surprised economists with an above consensus growth spurt of 2.2% in the 3rd quarter, driven in the main by Japanese exports and shrinking capacity in the industrial sector for the period. That shrinkage came as a result of increased exports as the dictates of comparative advantage of a weakened yen shifted decidedly in Japan's favor. Domestic consumption eked out a 0.1% increase for the period while corporate investment remained stubbornly flat, signaling that Japan continues to struggle in formulating a sustainable growth strategy that would lead to higher wages and increasing domestic demand for its goods and services. The yen has weakened for much of the month after hitting a market close of $102.99 to the dollar in the first week of November after hitting a high of $100.55 against the dollar in July. With the surprise turn of the US election, the yen has weakened even further with Friday's market close of $110.90. With the strengthening dollar, the trend for the Japanese currency is further weakening which is good news for Japanese export growth and likely overall GDP growth in the 4th quarter. Long positions on the yen, the Nikkei and the Topix exchanges should outperform through the end of the year with the Bank of Japan offering further appreciation as it invests ¥6 directly to major Japanese equity exchanges across the country. (Aberdeen Japan Equity Fund Ticker: JEQ)
In the emerging market arena, a strengthening dollar is mostly a double edged sword. While any increase in US government spending on infrastructure is good news for the export of commodities and industrial metals, a strong dollar and increasing US yields will pull so-called hot institutional capital from emerging markets which will apply upward pressure on emerging market interest rates and yields while simultaneously applying downward pressure on currencies which makes the repayment of dollar-denominated loans all the more difficult to service across the area. Emerging markets have issued a record $409 billion in dollar denominated debt this year, according to Dealogic data. The Mexican peso, a proxy for the ebb and flow of candidate Trump's presidential campaign has been hit especially hard, falling just over 12% from the election night results through the 11th of Nov, moderating modestly before weakening again to close at $20.6398 through Friday's market close. If a trade war materialized between the US and Mexico materialized, the hit on Mexican GDP growth could substantial. (ProShares Ultra Short MSCI Mexico Ticker: SMK). Elsewhere in the emerging markets space, the Brazilian real has fallen almost 8% from the election through Friday's market close. Similarly, the South African rand has fallen almost 9% during the period.
The biggest emerging market of them all is China and the renminbi continues to weaken in the face of the dollar's upward onslaught. The highly managed onshore currency has fallen to its lowest level against the dollar in the past eight years to CNY6.8883-its highest post since December of 2008. Despite the renminbi's recent weakness against the dollar, its value against a basket of currencies excluding the US dollar has actually increased on an undisclosed trade weighted basis against those of its other primary trading partners. Still, the People's Bank of China (PBOC) has burned through $18.9 billion in foreign exchange reserves in September alone in support of a weakening renminbi, according to PBOC data. That the PBOC is not intervening in a more heavy-handed manner to prevent the weakening renminbi likely signals the fact the currency is stabilizing against the currencies of most Chinese trading partners which keeps capital flight largely manageable--at least for the time being. China sports one of the world's highest savings rates which apply downward pressure on domestic consumption of goods and services in the greater economy. Much of this downward pressure results from exorbitant amounts of cash needed to buy an apartment in many of the major urban centers of China. Residential developers and home buyers consumer about 70% of all new credit created in China, according to Mizuho Securities Asia data which puts China on an even keel with the Japanese housing bubble of the 1980s. A weaker renminbi will likely be the price for propping up credit fueled growth and placing a floor under any precipitous drop in housing prices.
The more free-floating Hong Kong renminbi also remains pressured, closing at CNH6.9064 through Friday's market close. The offshore renminbi is up just over 1% since the US election as the dollar continues to strengthen.
The rising strength of the dollar is also a double edged sword for the US economy. A strong dollar greatly expands consumer purchasing power as foreign goods in US markets become cheaper. Domestic sellers whose revenue streams are largely derived from US markets will benefit as the exposure to exchange rate risk is minimized, such as small and regional banks and financial, retail and domestic service companies. Domestic sellers of goods and services also tie nicely into the Trump administration's protectionist "America first" credo. Of course those companies where sales of goods and services in foreign markets constitute an ever higher percentage of total revenue will not fare as well-either with the strength of the dollar which makes dollar denominated goods and services more expensive in foreign markets or with the "America first" orientation of future government policy. The de-emphasis on international trade policy by the administration could severely undermine corporate earnings. Global trade was flat in the 1st quarter and then fell by 0.8% in the 2nd quarter. The total volume of US imports and exports fell by just over $200 billion in 2015. That volume has declined further by $470 billion through the first nine months of this year-the first decline outside of a recession since WWII. According to data from the International Monetary Fund (NYSE:IMF), a 1% increase in global growth was responsible for an increase in trade volume of 2.5% in the 1990s. In recent years that same growth was increased trade by just 0.7%. With major free trade initiatives now under fire and new such initiatives being swept to the proverbial dustbins of history, the downward pressure on economic growth has likely intensified.
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