Why Goldman Is Not Buying Trump's Dollar Downer Rhetoric

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by: The Heisenberg

Summary

Goldman isn't happy.

The dollar, the bank says, is responding to rhetoric instead of fundamentals.

Once again, welcome to Trump's world. Settle in.

I have to tell you, this has been a fun week.

We've gotten to watch in real time as the market (and I'm using "market" here to denote all markets) tries to price the unpricable.

I've argued vehemently for the repricing of US equity risk. Last month was the third calmest January ever for US markets based on average VIX levels, underscoring the message sent by a "kinkless" S&P implied volatility term structure.

(Chart: Goldman)

Paradoxically, the Trumpian black swan has created complacency. How is that possible? Well, in an irony of ironies, it seems as though markets are so unsure about what Trump plans to do (on all kinds of fronts) that investors and traders have, like deer in headlights, simply frozen up.

We know how to price risk in other markets. Just look, for instance, at the kink in the VSTOXX curve:

(Chart: Bloomberg)

Or, for a more extreme example, look at the gyrations in the Turkish lira, where traders are used to responding to political turmoil on a minute by minute basis.

What we're not so good at is figuring out how to price uncertainty around the dollar (NYSEARCA:UUP) and USD denominated assets. Trump has introduced just such uncertainty and this week is the first time we're seeing markets try to negotiate it.

As I've been saying for months, the first place you're going to see the turmoil reflected is in FX markets and sure enough, the dollar is slumping against nearly all peers as traders try to discount Trump.

For its part, the Fed is frozen too. We saw that on Wednesday. As I put it early Thursday morning, the committee is "seemingly content to let Peter Navarro coordinate America's FX policy for the time being." Here's what the dollar has done since the Fed statement:

I wrote a ton about the greenback on Wednesday, presenting both the bull and bear cases, respectively.

One of the factors I flagged while suggesting that long USD dollar may not be such a sure bet after all, was rate differentials which, you'll note, have been the main driver of dollar gyrations for quite some time.

Well on Thursday, Goldman is out reiterating their long-standing long dollar thesis and the discussion centers around - wouldn't you know it - rate differentials. So adamant is the bank that the title of Thursday's note includes the word "not" in all caps: "This is NOT the end of the dollar bull run."

As it turns out, recent greenback weakness has taken the dollar below where the bank thinks it should trade based on a model that incorporates trade-weighted rate differentials. Consider the following (my highlights):

Interest differentials have been front and center to our bullish Dollar view. Empirically, they are the most important Dollar driver, leaving other factors like oil prices and global risk aversion far behind. Our standard regression model for the greenback links the trade-weighted Dollar versus the majors to the 2-year tradeweighted nominal rate differential, the Brent oil price, the VIX as a proxy for risk appetite and Euro periphery bond yields as a proxy for European break-up risk. Exhibit 2 shows that the "fit" of this model is remarkably good: it explains 95 percent of the variation in the Dollar since 2010, including the sharp rise in 2014/5. Much of the "fit" reflects the power of rate differentials, so that - as a first approximation - the fact that the Dollar (black line) has fallen below its "fitted" value (blue line) year-to-date reflects the divergence of the Dollar below the 2-year rate differential.

You'll note that a couple of weeks ago, I noted just how important it is to watch this very same dynamic.

While I - and others by the way, including former FX trader Richard Breslow - have argued the rate differentials may be set to move against the dollar on the back of higher inflation/growth expectations abroad and the possibility that the Fed may opt to go with SOMA rolloff as opposed to outright FF hikes when it comes to tightening. I'd also point to the fact that on Thursday, the BoJ failed to defend the JGB 10s when yields spiked above 0.10%. Goldman says that's all nonsense. To wit (my highlights):

The market is debating a variety of explanations for this residual: i. better growth abroad, in particular in the Euro zone; ii. a building expectation for an inflation overshoot in the US; and iii. balance sheet run-off as an alternative to Fed hikes. None of these fit what the market is trading. The first hypothesis, which is often mentioned in the context of ECB tapering, should see nominal rate differentials move against USD, but instead they are stable. The second should see real rate differentials move against the Dollar, pulled lower by rising inflation compensation in the US. As Exhibit 4 shows, this is also not the case. Fed balance sheet run-off should see nominal differentials at longer tenors move in favor of the Dollar, as the US yield curve steepens. If anything, the opposite is the case. In short, most of the explanations that are being debated don't fit the facts. In particular, there is no evidence that real rate differentials are moving against the Dollar.

Well ok then. So what, one might fairly ask, explains the weaker dollar?

The answer should be self-evident, but in case it isn't, here's Goldman to explain:

The principal reason for the divergence is "Dollar down" rhetoric from the new administration.

Needless to say, Goldman - like Credit Suisse - thinks "tweet risk" will eventually give way to the reality that the proposed policy mix and other structural factors favor a stronger greenback.

That said, one has to wonder whether both banks are making the same mistake Trump detractors made when they assumed he wouldn't follow through on his more controversial campaign promises.

That is, if Donald Trump says he wants a weaker dollar, then by God he's going to get a weaker dollar. Said differently, I'm not entirely sure the fundamentals are going to win out here.

"A policy mix that combines fiscal stimulus and protectionism is hard to reconcile with a weaker currency, even if that is what the new administration wants," Goldman concludes.

We'll see. We'll see.

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.

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