The dollar posted its fifth consecutive quarterly loss through the end of the 1st quarter. Theories abound but evoke little in the way of consensus. Many investors bet long on the dollar in anticipation of repatriated corporate cash hoards washing ashore in the wake of the Tax Cuts and Jobs Act (TCJA) passed by Congress this past December. Apple (AAPL) announced recently that it repatriated the majority of its $269 billion in overseas cash. For the same amount of money, the Apple board could have purchased all the shares of 275 of the companies listed on the S&P 500, according to news reports. Others took a contrarian view given the high level of political uncertainty in Washington from botched US policy initiatives, to the ever-revolving door of senior appointees to the endless litany of scandals and lawsuits that paralyze policy making of the current administration. Still others saw the economic gloom of pending and countervailing tariffs slipping into a bona-fide trade war, sinking markets in its mud-slinging wake. And now with last week's headline PCE number hitting 1.9% on the heels of the Employment Cost Index showing wages and salaries through the end of the 1st quarter at 2.9%, investors are worried that surging inflation this late in the economic cycle will prompt a more aggressive monetary policy stance by the Federal Reserve, choking off further economic growth. The headline wage growth of all nonfarm workers came to 2.56% in April, not much faster than the pace of headline inflation, was welcomed with an expansive sigh of relief.
Figure 1: The Dollar, the Yen and the Euro Indices during the Bush Tariff Regime, January 2002-March 2004
The dollar, indeed, has historically weakened in the face of market disruptions caused by tariff regimes, falling almost 14% during the 15-month Bush tariff regime that spanned March of 2002 through December of the following year (green line). The dollar would reverse course rather quickly with the turn of the New Year 2004 with a 4-standard deviation move by late February and into the beginning week of March 2004. Meanwhile, the euro (green area) muscled its way to the upside peaking just short of $1.28 as the dollar hit rock bottom. The yen (gold dashed line) took a more muted path, underperforming the dollar for the entirety of 2002 before strengthening by May 2003, outperforming the dollar through the end of March 2004. The yen displayed a strong correlation with the euro from October 2003 through the end of March 2004 (see Figure 1, above).
Figure 2: The Dollar Index, the Yen Index and the Renminbi Index against the Euro Index
Fast forward a number of years and the US is once again at the forefront of launching a steel-based tariff regime, this time targeting China rather than the EU. The dollar (UUP) (green line) has been weak since peaking in early December 2016 in the aftermath of surprise Trump victory in the US presidential cycle. From peak to trough through the end of January 2018, the dollar has dropped just under 14% to its lowest post since July 2014. The dollar would revisit its January low in the closing days of February before bouncing off of its lower Bollinger band, surging the better part of 4-standard deviations by the end of the first week in March before staging another retreat as the Trump tariff regime proposals were announced. From the first week in March to the first week in April, the dollar would cover another 4-standard deviation-this time to the downside. Reversing itself yet again, the dollar broke through its 200-day moving average for yet another 4-standard deviation+ move for its highest post since the last week in December 2017.
Meanwhile, the euro (FXE) (green area) has steadily gained strength against the dollar since eking out its own trough in December of 2017 with a three-year high sketched out in early February. The yen (FXY) (gold dotted line) underperformed the dollar through the end of July before putting together a run of strength that outperformed the dollar through the end of October before again heading to the upside in early January and peaking in mid-March and beating a hasty retreat in the wake of the US tariff proposals. And the renminbi (CYB)'s (black dotted line) weakness has now coincided with the broadly-based dollar rally, adding yet another level of complexity to US-China trade tensions. The dollar has gained just over 1% against the renminbi, 3.2% against the euro and 1.7% against the yen through Friday's market close. While the renminbi has declined less than the yen or the euro against the dollar, the distinct lack of progress in the two-day US-China trade negotiations in Beijing last week will likely be pressured to the downside when market open next week. The question moving forward for the renminbi is just how aggressive the PBOC response will be to the further weakening of the renminbi against a currency basket of its major trading peers (see Figure 2, above).
A 4-standard deviation move by the dollar, it goes without saying, implies a perfect storm-sized level of market momentum. At last check, investors still labor in the long shadow of tariffs on an ever-growing array of goods sold by the two largest economies on the planet, which should otherwise propel the dollar decidedly to the downside. Despite these storm clouds, the dollar has been buoyed in the last week by an array of strong economic data, such as headline inflation closing in on the Fed's target of 2%, coupled with the strong 1st quarter showing of wages and salaries growing at an annualized rate of 2.9% in the latest Employment Cost Index, mitigated somewhat by a 2.56% YOY wage growth finding by the Bureau of Labor Statistics in April's job report alluded to previously.
In a break from its usual descriptive language, the statement from this week's FOMC highlights the task of monitoring actual and expected inflation relative to the Committee's symmetric inflation goal. The wording appears to have conveyed some added comfort to markets and investors alike. The Committee's 2% inflation target is not intended to be a hard and fast cap on price movements in the greater economy beyond which monetary policy action is automatically triggered. The measure therefore contains flexibility, a determining range that could extend plus or minus about the target. Wages should be able to grow at the rate of productivity plus 2 percentage points since the higher the rate of worker productivity, the less wage growth drives overall costs higher. The current level of productivity through the end of the 1st quarter came to 1.3% for non-farm business YOY and 1.5% for durable manufacturing. That implies a range of wage measure of 3.3% overall and a 3.5% growth level for manufacturing, outlining the possible limits of the Fed's inflation target symmetry.
Of course, monetary policy tightening is on the rise as investor expectations almost universally see the Fed delivering three upticks in the federal funds rate for the year, conveniently saved for the June, September and December FOMC meetings, which stage press conferences. The probability of a fourth uptick, now at 50%, would have to put either the July or the November FOMC meeting in play. The FOMC statement supplied little further elaboration on the issue. While flexibility on inflation is likely good market news for those investors fearing an overtly aggressive Fed response to price levels in excess of 2%, inflation in the greater economy has never exceeded the 2% target since the Fed adopted its inflation target in 2012. TCJA and increased government spending stemming from the $1.3 trillion budget compromise could increase domestic demand for goods and services, which invariably provides a boost to imports, a subtraction from GDP output. Tariffs generally apply upward pressure on prices, particularly targeted imports, and downward pressure on economic growth. The FOMC statement gave no indication the Fed is contemplating a change in the current pace of upticks to the federal funds rate.
That said, the stimulative potential of tax cuts, increased government spending and market distortions from possible tariffs all add greater dollops of uncertainty to inflation expectations moving forward. Stocks have come under pressure since Caterpillar (CAT)'s earnings announcement that profits for the company had likely peaked during the quarter for the rest of the year. Markets remain cautious. No doubt swallowing hard several times after the FOMC release, investors nonetheless sent the S&P 500 tumbling 19-points on the day. Another six points were added to the downside on Thursday, sending the benchmark through its 200-day moving average. Friday's jobs report went a long way toward soothing market angst. While the jobless rate fell to an 18-year low of 3.9%, inflation worries subsided with wage growth posting a more market comfortable 2.56%, a level not much above the rate of inflation, sending the S&P up 1.3% on the day.
Figure 3: 10-year Treasury, Bund and Japanese Note Yields against the 10-year US Treasury - German Bund spread
Monetary tightening continues as the Fed's portfolio reduction program now subtracts $30 billion of liquidity per month through the 2nd quarter by not reinvesting proceeds from maturing Treasury securities in its portfolio. Financial conditions in the greater economy fell to a reading of -78 in the week ending 27 April, a steady improvement from a peak reading of -88 in the last week in November. The dollar has responded positively in anticipation. The strengthening of the dollar comes largely at the expense of the euro, the yen and the renminbi as all three currencies weaken against the dollar. With headline inflation flirting around the Fed's 2% target, headline inflation in the EU fell to 1.2% in April, down from 1.3% in March. Headline inflation in Japan remains less than 1% YOY. The BOJ recently dropped its 2% inflation target in a forced recognition that prices are much less sensitive to monetary policy after years of large-scale asset purchases. Japan's unemployment rate hit an all-time low of 2.5% with the jobs to applicant ratio hitting a 44-year high at 1.54 times. By Japanese standards, the US labor market, now at 3.9% which is the lowest post since April 2000, perhaps has more slack to shed. Then again, unemployment rates do tend to fall when large numbers of workers drop out of the labor force during the survey period. In April, 236,000 workers fell outside the parameters of the survey, causing the labor participation rate to fall slightly during the month to 62.8%, down from 62.9% in March.
Both the ECB and the BOJ continue to buy sovereign bonds in support of their respective economies, effectively placing an artificial cap on yields. The 10-year Japanese note has a yield of 0.045% (blue line), while the yield on the 10-year Bund (purple dashed line) closed at 0.5810%. This suggests that yields in both Germany and Japan are more reflective of central bank decisions than any market-determined notions of supply and demand. It also means that bond yields in Germany and Japan could surge when economic conditions rather than central banks set term premia. In the meanwhile, the 10-year Treasury note (red line) carries a yield of 2.97% at Friday's market close. The 10-year Bund and the 10-year US Treasury spread (green area) is 241 b/p-the largest spread since December 1988 (extended box). The 10-year Japanese and the 10-year Treasury spread is now 293 b/p-the largest spread since August 2007 (extended box). The resulting arbitrage in the favor of US assets will work to cap both US borrowing costs while providing foreign investors outsized incentives to finance the ever-burgeoning US fiscal and current account deficits until such time when the BOJ and the ECB end their respective their asset purchases that continue to depress yields (see Figure 3, above).
Of course, the elephant in the room is the US Treasury and its efforts to keep pace with increases in government borrowing over the next decade. The US Treasury borrowed $488 billion through the end of the 1st quarter, a record. The country's fiscal deficit bulged by $600 billion halfway through the year as government spending ballooned three-fold between October and March with the passage of the $1.5 trillion tax cut in December and the $1.3 trillion spending compromise in early February. The tax and spending packages will blow an $804 billion gap in the current fiscal year and will surpass $1 trillion by 2020. The sheer volume of money the government needed to raise during the 1st quarter pushed the yield on the 10-year note momentarily above the psychologically important 3% threshold last week for the first time since January 2014. Breaching the 3% threshold is extremely important due to the role the 10-year note plays in setting borrowing costs throughout the greater economy-from mortgages to car loans to loans for households and business. The need to pull additional funding from the economy will likely push yields even higher, raising the borrowing costs of both government, corporate and household borrowers. Higher borrowing costs could eventually become a drag on economic growth.
Since US borrowing needs vastly outpace US savings in recent years, foreign capital becomes all the more critical to closing fiscal and current account deficits. Through the end of February, foreign countries hold just under 30% of the $21.0 trillion US debt, or $6.3 trillion, up almost 5% YOY. Foreign holdings of US debt have risen almost six-fold from the beginning of the 21st through the end of February and 168% since the official declaration of the Great Recession of 2007 in December of that year. The growing share US debt comes at a time when the 10-year Treasury yield topped 3% last week for the first time since 2014, with expectations for further increases in long-term yields in the wake of the December tax cuts and February budget compromise for $1.3 trillion, increasing the demand for government borrowing to meet new spending levels. With the ballooning of both the country's fiscal and current account deficits coupled with the continuing decline in domestic savings, US dependence on foreigners to finance the country's growing debt is all but assured.
The US trade deficit weakened slightly for the month of March for goods and services, falling $8.8 billion to $49 billion for the period. The three-month average decreased $1.7 billion to $54.5 billion while the deficit was up $8.5 billion YOY. Exports were up 4.8% in the 1st quarter's advanced estimate on the quarter, adding to the 7% advance for the final accounting of 4th quarter GDP growth. The weak dollar bolstered US export sales in world markets. Of course, a stronger dollar traditionally bolsters imports as household purchasing power increases vis-à-vis other world currencies. Even though 4th quarter export growth gained 7%, consumer demand for imported goods and services grew twofold, subtracting 1.16 percentage points from GDP output for the period. If the dollar surge continues, US exports will likely lose their comparative advantage in world markets, pressuring the earnings of US exporting companies.
In the emerging markets space, a weak dollar boosted commodity prices in local currency terms while making debt service payments on dollar-denominated debt more manageable and muting price inflation in the greater economy. Shares of indebted EM companies fell sharply with the sudden upward thrust of the dollar in the closing week of April. Commodity prices, largely denominated in dollars, fell as the value of the dollar adjusted to the upside, reaching its highest post since December. EM markets held a record $6.3 trillion in dollar denominated debt with Turkey, Argentina, South Africa and Colombia being particularly vulnerable to a strengthening dollar. Argentina's central bank has raised interest rates three separate times in the course of the week, leaving its main lending rate at a whopping 40% in a valedictorian attempt at defending the peso. Devaluation appears to be part of the near-term picture. So much for the country's successful float of a 100-year dollar denominated bond last year. Retail demand for gold in Turkey has surged in recent days as domestic investors stem losses in the wake of a fast depreciating lira and inflation hitting double digits during the week. With elections scheduled for next month and the country's currency in freefall, some form of fiscal stimulus in likely on the way for the beleaguered Turkish economy. Moody's already downgraded the country's sovereign debt to two notches below investment grade in March. Indonesia has seen its equities benchmark fall over 2% for the third time since mid-week. The country is highly sensitive to changes in institutional capital flows given that foreigners own about 40% of Indonesia's sovereign debt. Central bank intervention calmed currency markets as the rupiah weakened against the dollar. Meanwhile, investors have pulled an estimated $8.4 trillion from EM assets in less than two weeks.
Further evidence of renewed investor interest in dollar-based assets comes from the noted slowdown of economic growth in the euro-zone, which fell to just 0.4% in the first three months of the year, a decline of 0.3 percentage points YOY. This is the slowest growth rate for the single currency bloc since the summer of 2016, raising sustainability questions moving forward. While hard data on the trend is still forthcoming, preliminary survey data suggests the slowing of manufacturing, retailing and service across the euro-zone as the fallout of renewed sanctions in Russia and a looming trade spat with the US appears to be squeezing the bloc's export-based economy. In lieu of an EU-US agreement on a permanent tariff exemption on steel and aluminum, the Trump administration gave Brussels another 30-day extension. With little movement to date on voluntary restraints being implemented, which are illegal under WTO rules, and further disagreement on a tariff differential on imported cars, little movement is expected as market uncertainty grows.
Last week's US-China trade talks were largely over before they got started. Worse, the talks produced neither agreement regarding the principals under discussion nor on whether the two sides should meet again. Wednesday's initial meeting in Beijing saw both sides strenuously reigning in even long-shot expectations on finding common ground. News reports quickly relayed the unwillingness of the Chinese to give any ground on the three quite disparate US demands of curtailing the country's Made in China 2025 program, arbitrarily cutting the US-China trade deficit by $100 billion and reciprocal market access.
There is little the US or international trade is going to be able to do to curb China's industrial policies. China plans to spend Rmb300 billion to seed a domestic semiconductor industry. Given the level of government funding, industry experts fear a glut of chips on world markets putting downward pressure on prices as a likely result if the effort is successful.
An arbitrary reduction of China's trade deficit is equally difficult, which is the trade lawyer approach to the US-China relationship seen solely through the guise of unfair trade practices while largely ignoring other, more endemic macroeconomic issues. The US-China trade deficit would likely disappear if China had buying excess to US high technology products, applications and companies where the US still maintains a significant trade advantage. High technology sales by US companies are off-limits to which the recently quashed bids by Singapore-based Broadcom (BRCD) for San Diego-based Qualcomm (QCOM) and QCOM's bid for the Dutch chip maker NXP (NXPI) over which China has regulatory input duly attests. Recent bans imposed by the US on the Chinese telecom behemoths ZTE (OTCPK:ZTCOF) and Huawei on national security grounds further underscores the notion that high technology will not be a part of the US-China trade relationship any time soon as a literal cold war on technology transfers appears to be in place.
Beyond the US trade advantage in technology, China's upper hand in consumer goods and low- to mid-end manufacturing comprises the stuff of the country's trade surplus with much of the rest of the world. In the energy space, the US only recently allowed US-produced oil to be exported to countries outside of Canada. The infrastructure to boost foreign natural gas sales is still work in progress. Grain sales are clearly under the tariff knife as China buyers have halted purchases in the face of the country's 179% import tariff on sorghum, announced last month. Chinese buyers ordered 255,000 metric tons of US soybeans during the week ending 5 April. That total has now dwindled to just 11,000 metric tons-with the remaining orders facing a high probability of cancellation. This new trade reality has forced China to actively source non-US suppliers of sorghum and soybeans from peripheral producers like Mexico, Indonesia, Vietnam and Turkey. Meanwhile, US grain farmers have seen their export market, already reduced by stiff competition from Russia and Brazil in recent years. US soybean exports held on to a 37% market share through last season, down from about 70% in the 1970s. Being shut out of the Chinese market this growing season could further erode US global market share.
On reciprocal access to each other's markets, this is an area that could present a modicum of movement allowing both sides a path toward saving face. China cosmetically lowering import tariffs on foreign cars, phase-out dates for JV partnerships arrangements, opening Chinese markets to international finance, even offering to reduce China's $375 billion trade surplus through the purchase of more US semiconductors and agricultural products are all past announcements currently in the public domain. But even here in the context of the high-profile decisions already made to curtail trade in the technology and agricultural spaces mixed with the negative atmosphere created by countervailing proposals on tariffs yet to be implemented, good will on either side is in short supply. The administration's decision to dispatch a high-profile, outwardly disparate delegation to China held together with few common policy threads without the benefit of a forward technical team hammering out the groundwork of a potential agreement beforehand, allowed markets to assume the worse. Two days later, markets weren't disappointed. Planned meetings of US officials with President Xi Jinping and Vice President Wang Qisham were abruptly canceled at the last moment. There now appears to be little standing in the way of a miasmic, full-blown trade conflict erupting between the two countries. Over the longer term, a lasting trade agreement looks to be years in the making, making interim Chinese concessions on such obtainable face-saving measures highly implausible given the uber-charged political environment.
Sifting through the market noise both here and abroad, momentum continues to favor a stronger dollar for many of the reasons cited above. Capital flows leaving the EM space for safe harbor vehicles aptly captures current market sentiment. A stronger dollar, rising inflation, the federal funds rate on the uptick are rarely a growth-inducing EM mix. The resulting flows that wend their way back into dollar-based assets help keep downward pressure on Treasury yields and borrowing costs reasonable for government, corporate and household debtors-at least for the time being.
That said, perhaps the biggest cause of dollar weakness to date ties inextricably to burgeoning US trade and budget deficits, which, unsurprisingly, points to the current dollar rally as having no legs. And a strengthening dollar in the face of a full-throated trade war has little historical precedence. High EBITDA posts due to last year's tax cuts in the US notwithstanding, two possibly three more upticks in the federal funds rate could pressure earnings as interest costs take bigger and bigger bites from bottom line computations. The proportion of US loans with a rating of single B or below has gone from about 25% in 2007 to about 65% through the end of 2017. A stunning 75% of all institutional loans issued in 2017 carry fewer and fewer protections for investors in case of a default. Rising rates will bite at some juncture without doubt. Meanwhile, the dollar's direction remains largely enigmatic.
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