I think it's important that we take a moment to flag what's likely to be a key concern going forward.
In a post on Thursday, I suggested that "it's time to start worrying about FX vol." My contention is that political uncertainty is going to make for turbulent times in currency markets. This is likely to be exacerbated by the increasingly blurry line between monetary policy and politics. Here's an excerpt from the piece linked above:
To be sure, it's nothing new for markets to trade off policymaker soundbites. That said, I'm concerned that in the fog of uncertainty (Brexit worries, concerns around elections in Europe, the looming showdown between the Fed and the Trump administration over dollar strength, the Politburo's control over RMB policy, etc.), the divide between politics and monetary policy is disappearing. Indeed, political expediency may require that the two be merged. That could make it decidedly difficult for FX markets to determine who's ultimately in charge and whose comments should be given the most weight.
Have a look at a simple, one week chart of the broad dollar that shows the push and pull dynamic between politics and monetary policy:
Who's driving this bus, anyway?
"Donald Trump wants a weaker Dollar; Janet Yellen stresses Fed independence; Chinese authorities don't think the Yuan need necessarily weaken," SocGen wrote earlier this week, adding that "some people wonder whether we're going to get a 'Trump Accord' to rival Trump Plaza" (that's a play on words with the 1985 Plaza Accord).
Now forgive me, but what the hell is a "Trump accord?" I mean the new President has already effectively hijacked the boardrooms of several companies (think General Motors (NYSE:GM) and Lockheed Martin (NYSE:LMT)), are we now going to see the him try and dictate monetary policy?
The answer is "probably". After all, he's already dipped his toes into monetary policy once by criticizing Janet Yellen for keeping rates too low for too long. Never mind the fact that in the current environment, raising rates is entirely incompatible with his call for a weaker dollar (NYSEARCA:UUP).
And look, if Trump somehow forces the dollar lower, that might be good for US companies and for the economy - who knows. I'm not trying to disparage Trump. I'm just trying to emphasize the fact that, as Credit Suisse put it on Wednesday, "politics continues to be the key driver of FX volatility." And that's kind of scary given the current political environment both at home and abroad.
The same dynamic is playing out in the UK, although I'm not sure dictating the direction of the pound (NYSEARCA:FXB) is necessarily on Theresa May's radar to the extent that the "too strong" dollar is on Trump's.
And don't forget about the fact that the euro (NYSEARCA:FXE) is subject to considerable political risk in 2017 as well, thanks to upcoming elections across the EU. As I wrote earlier this week, "EUR/GBP dynamics would completely change if Marine Le Pen, Geert Wilders, or Frauke Petry's AfD were to outperform election expectations."
Oh, and then there's the EM wild cards: the Turkish lira, the Mexican peso, and the Chinese yuan (NYSEARCA:CYB), all of which are effectively beholden to politics in one way or another (Trump is the worry for the peso, Erdogan for the lira, and a combination of Trump and the Politburo for the yuan).
So anyway, less than 24 hours after I posted the piece linked at the outset, a new article from FactSet entitled, "Currency: Volatile, Unpredictable, and a Growing Concern", hit my inbox. Here are some key excerpts (my highlights):
2016 was a year of shifting macroeconomic sands-and currency markets bore the brunt of the turmoil. From the devaluation of sterling in the wake of Brexit to the slide in the Mexican peso following Donald Trump's presidential victory, currency fluctuations have had a profound impact on portfolio returns.
Portfolio managers have been forced to pay closer attention to currency because of both push and pull factors. Currency has been a significant source of differentiation between funds, particularly in countries with political upheaval. For example, the FTSE 100 index is up 14.43% for the year to date (as of January 13) in local currency terms, but USD investors would have seen their investment fall by 4.07%.
Even where currency fluctuations have not been as steep, they have made a difference to investor returns. The Nikkei 225 is up 3.58% in USD terms over the same time period, but only 0.42% in yen terms. As such, the difference between a hedged and non-hedged portfolio has been dramatic.
FX volatility appears likely to continue. Implied volatility for the euro is moving higher, as 2017 promises to be a year of political drama on the continent. And with the Fed having raised rates, but quantitative easing persisting in Europe, Japan, and the UK, monetary policy is diverging, which may create currency volatility.
I couldn't agree more.
The question for retail investors is whether FX vol spills over into equity markets, where volatility has been remarkably subdued despite rising geopolitical risk.
As I pointed out previously, anyone riding the wave in US equities had better hope that the dollar continues to rise, or if it doesn't, that the correlation between the dollar and stocks reverses:
For those wondering where they might find shelter if and when political upheaval causes vol to spike across markets, you could always buy shiny, yellow doorstops (NYSEARCA:GLD).
On that note, I'll give the last word to Bloomberg's Mark Cranfield (my highlights):
Some analysts will point to the threat of a higher dollar and rising U.S. yields as factors against gold. And that's certainly been the direction of markets in the weeks since the presidential election. But gold now appears to be diverging from the broad performance of bonds, the dollar and equities.
The argument that gold doesn't have any yield is also less relevant when two of the biggest currencies on the planet - the euro and the yen - have negative short-term interest rates
Witness this week's dollar sell-off after Trump said the dollar was too strong. It was probably meant as a throw-away line, but it still roiled markets.
Scary geopolitical headlines in the next four years are just as likely to come from Pennsylvania Avenue as they are from Pyongyang.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.