The Rising U.S. Dollar Poses Risks To The Global Status Quo

Summary

• The U.S. dollar is likely to continue appreciating based on Federal Reserve policy, higher real U.S. yields, and a deteriorating global environment while the U.S. economy decouples and performs.
• Emerging markets are on the cusp of a currency crisis. This is already becoming apparent in Indonesia, Turkey, Hong Kong, and Argentina.
• Europe and Japan's data misses are becoming increasingly more worrisome and support their central banks "doing more" or extending easing.
• China's and more generally emerging market's USD-denominated corporate debt situation poses a major risk as well and bears "close watching" according to Jerome Powell.
• The closely watched gauges of the global economy, copper prices and South Korean exports, appear to be rolling over.

Despite the somewhat bearish global outlook I am depicting in this article, there is little reason to believe the Federal Reserve will not "look through" a lot happening globally and take care of its own house focusing on the dual mandate of max employment and 2% inflation. I've long called for the U.S. economy to lead the global economic growth cycle and disengage from the global economy allowing the Federal Reserve to normalize while facing global headwinds. Fiscal stimulus on top of an economy operating at full employment with target rate inflation reinforces the Federal Reserve continuing on its current trajectory.

Real inflation-indexed 10-year treasury yields have just surpassed the Bernanke Taper Tantrum highs in 2013. Given the fact that relatively low nominal yields and high inflation expectations are drivers of currency depreciation, the opposite also holds true. Low or stable inflation expectations with rising nominal yields supports a currency appreciating. This is depicted below in the 10-year inflation-indexed security. It is simply, nominal 10Y yields minus market-based inflation expectations. As the inflation-indexed yield goes up, it provides more power for the U.S. dollar to move higher in my view.

Another factor in foreign exchange rates is interest rate differentials. The closely watched U.S. dollar DXY index is heavily weighted versus the euro. The U.S. 10Y Treasury yield minus the 10Y German Bund yield is at a multi-decade high. This is a major supportive factor for the U.S. dollar. Richard Benson, who helps manage $20 billion at Millennium Global said:

The very slow and gradually widening interest-rate differentials against the euro have now reached a tipping point where that is very powerfully positive for the U.S. dollar

Many are calling for a blowing out of the U.S. deficit leading to an inflation-driven deprecation of the U.S. but I believe this is premature. An overemphasis on the long term is causing investors and fund managers to overlook the near-term bullish picture. According to Peter Jacobson, managing director at Rhicon Currency Management (who oversees $700 million):

People are probably focusing on the deterioration of the U.S. balance sheet as a whole and how the twin deficits blow out, looking forward 5, 10 years... The market is being too clever in looking that far down the line. The deficit in the U.S. is going to be problematic, but that’s later on.

Also, for those predicting significantly higher inflation, the United States' M2 money supply growth is a rather sobering chart. An inflationary overshoot would be accompanied by rising M2 growth rates, not falling.

In emerging market currencies and equities, it is starting to look much more risky. According to Bloomberg as of April 2018, emerging market carry trades went into the red:

After climbing as much as 4 percent this year, a Bloomberg currency index that measures carry-trade returns from eight emerging markets, funded by short positions in the greenback, has given up all its 2018 returns.

One month later, the same trades have hit the lowest returns in a year. The MSCI Emerging Market Currency Index crossed below its 200-day moving average last Friday, a sign of further losses and technical downside momentum. In Indonesia, bond yields are rising (as a result of rate hikes to prevent capital flight) and the rupiah is still selling off. The USD/IDR hit the highest level since late 2015. Indonesia's central bank has intervened a "sizeable" amount to defend the currency through utilizing foreign exchange reserves.

Source: Heisenberg

The Turkish lira has hit a fresh record low against the U.S. dollar. The USD/TRY rate is now 4.65 compared to 1.85, exactly five years ago. Much of this has to do with Turkey's President, Erdogan, commandeering monetary policy with an unorthodox theory that higher interest rates fuel inflation. This has led to the central bank, not raising interest rates to defend the currency leading to a wave of bearish speculation against the lira.

Source: Heisenberg

In Argentina, the central bank has raised its benchmark rate to a staggering 40% in an effort to defend the peso which fell 20% in the last month alone. One-tenth of their foreign exchange reserves are spent and Argentina is asking for a loan from the IMF to further defend the currency. Meanwhile, The central bank of Hong Kong has spent $2.4 billion in a week to defend the HKD from speculative pressure.

According the Carmen Reinhart (Harvard economist):

"The overall shape they’re (EM) in has a lot more cracks now than it did five years ago and certainly at the time of the global financial crisis

Also in an interview with Bloomberg TV she states:

It’s very reminiscent of the taper tantrum. That proved to be a false dawn because rates didn’t continue rising from there. In fact, they went to new lows in 2016. This time, we don’t see that. Everything’s been thrown in reverse. You won’t see more QE. You won’t see more rate cuts. In fact, you’ll see the opposite

In my view, the Taper Tantrum 2.0 risk is real except perhaps more significant as the Federal reserve is firmly tightening and won't pause the minute there is turbulence. Carmen Reinhart seems to agree. Will the downside momentum in emerging markets be contained to the above countries' economies? Time will tell, but if one believes the EM version of the "canaries in a coal mine" idea, the canaries are looking rather unhealthy. According to Bloomberg:

Some $249 billion needs to be repaid or refinanced through next year, according to data compiled by Bloomberg. That’s a legacy of a decade-long debt binge during which emerging markets more than doubled their borrowing in dollars, ignoring the many lessons of history from the 1980s Latin American debt crisis, the 1990s Asian financial crisis and the 2000s Argentine default.

The million dollar question is what to make of the Chinese economy and the yuan? The yuan, after posting a great 2017, is declining versus the dollar recently. Remember it wasn't too long ago (late 2015, early 2016) that the PBOC was facing a full out run on the currency. This ignited bearish sentiment in stock indexes around the world. I won't cover China's economic fundamentals and financial stability risks in this article, as I have made my points numerous times, but feel free to reference "Synchronized Global Growth Faces Major Risk" for further reading on China.

A quick fact on China before moving on is corporate debt is at an elevated 170% of GDP and a significant amount of this figure is denominated in the U.S. dollar, which makes it more difficult to service when the USD appreciates. China has close to $100 billion in foreign currency debt maturing within the next year.

Federal Reserve Chair, Jerome Powell, has said:

The corporate debt situation in emerging markets has been worsening, particularly in China, and market reactions to even small surprises can be unpredictable and outsized.

A piece of illuminating info I found via The Heisenberg Report is South Korean export growth going negative, which is an ominous sign for the global economy. The correlation between South Korean export growth and global EPS is remarkable as depicted below. Copper has also seen a year-to-date decline and its inverse correlation with the USD poses downside risks to copper prices if the USD continues broadly appreciating.

China's transition from the old, industrial and investment driven economy to more of a consumer-based economy does not bode well for copper either (and it's questionable whether that transition will even happen smoothly). Copper and South Korean exports are two closely watched barometers for the global economy and both appear to be rolling over.

Japanese data has really been quite a disappointment recently. Japan's economy contracted in Q1 for the first time in 9 quarters, while household spending fell 0.7% from a year earlier marking the second straight month of declines. Core inflation is running at a meager 0.9%, far below the Bank of Japan's target rate.

In Europe, GDP, inflation, business sentiment surveys, PMI data, and numerous other data points have failed to meet expectations. This slowing in economic momentum has underpinned the USD/EUR. Why the Eurozone economy has hit a soft stretch is up for debate, but I would attribute it to higher yields, a stronger currency weighing on exports, expectations for a less dovish ECB, equity volatility and global trade concerns.

The European economy is an export-driven economy at 40% of GDP compared to around 15% for the United States, so the global trade tensions are especially concerning for Euro area economies. I am in the camp for a "soft" taper by the ECB in September, down to 15 billion or 10 billion in purchases a month from 30 billion, rather than an outright end. Forward interest rate guidance will also remain extremely and purposefully dovish in my view which will place downward pressure on the euro. Italian politics is also a recent development and a negative factor for the euro currency.

In essence, the debate for the ECB and Bank of Japan to extend easing or "do more" is becoming increasingly tilted in favor of the doves. Given that the Federal Reserve is already tightening and unwinding the balance sheet, while ECB and BoJ balance sheets continue to grow and will maintain a max for an extended amount of time should propel the U.S. dollar higher.

A factor to watch for from the Federal Reserve is decreasing transparency and forward guidance. St Louis Federal Reserve President, James Bullard, has made the case that he would like to return to a more opaque monetary policy similar to the Greenspan years. He states:

“The whole idea that you’re naming the number of rate hikes way out into the future when you don’t know what the data are going to be is something we should get out of the business of doing...When you’re at zero and you’re giving forward guidance, that’s one thing. But we’re not at zero anymore.”

Newly appointed and influential President of the New York Fed, John Williams, made a similar point. He said:

We can’t keep talking about policy normalization once we’re around what we think of as a neutral interest rate... So I think this forward guidance, at some point, will be past its shelf life.

This suggests monetary policy is quickly becoming less accommodative and the language in the FOMC statement warrants a change. A change in the FOMC statement from "the stance of monetary policy remains accommodative" to something more neutral would be in my view bearish for treasury prices and lead to a further rise in yields.

I will conclude with an idea stated by Stephen Innes of OANDA, that goes well with the premise of the article, that is, the appreciating U.S. dollar is exposing cracks in the global economy that not necessarily were not there before, but were at least less apparent. That is, the U.S. dollar is the new VIX and the status quo can quickly be disrupted by an appreciating U.S. dollar.

Disclosure: I am/we are short GG, ABX, FCX, RGLD, WPM. 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.