Welcome To The August Doldrums In Eastern Europe
Being a native-born European, I decided to pack my bags in August, European style, and go visit my friends and family in my homeland of Bulgaria. August is the month when all of Europe (not just me) pack their bags and head for the beaches, so European markets are (at best) illiquid as trading volumes decline and surprising headlines generate bigger moves than they would otherwise be able to cause.
With the Chinese yuan dangerously close to 7:1 against the U.S. dollar - last week, it reached 6.92 - I do not believe that the Chinese will make a trade deal before the majority of Trump's tariffs go into effect on September 5, as they would feel that their hand has been forced. I think President Trump needs to find an expert on Asian business dealings and get some consulting expertise on a way out of this situation so that the Chinese can "save face," which is the modus operandi of Asian diplomacy. So far it looks like the current trade friction - filled with acrimonious recrimination - will drag into September and October.
In this scenario, there is nowhere for the dollar to go but up, as the Fed has reaffirmed its tightening bias in a U.S. economy that is roaring near full employment. I see the Fed tightening in a real trade war, but since the fate of the trade standoff will be decided in September or October, the dollar has significant room to run to 100 or higher on the U.S. Dollar Index, which made a beeline from 90 to 95 early in 2Q. Now that those gains have been consolidated around 95, the next beeline is to 100 or higher, in my view, particularly if the "acrimonious recrimination" part of the Chinese trade negotiations reaches fever pitch.
The 2-10 Treasury spread - one of the more popular measures of the slope of the Treasury yield curve - was as low as 24 basis points in July. What's more interesting, the 10-30 spread closed at 17 basis points last week, which means the long end of the Treasury curve does not see inflation but deflation, which would be the natural outcome of a bad trade war. Any way you slice it, the Fed is one FOMC move away from inverting the Treasury yield curve, which has had an ominous predictive power of future recessions.
It looks like the yield curve will invert in September or October, with or without a trade war. In the event that a worst-case scenario plays out (a 20% chance, in my view), the effect will be profoundly deflationary for the global economy as the Chinese will feel compelled to devalue the yuan to 8-9 per dollar, at which point the Fed will stop hiking and the Treasury market will rally. We are not there yet, but I believe the best modus operandi now would be "Hope for the best and be prepared for the worst."
The Dollar/Emerging Markets Empirical Test
Travelling through Bulgaria, I noticed the long-standing weak dollar vs. strong emerging markets correlation holding up pretty well. If one looks closely, the euro is positively correlated to Bulgaria's SOFIX stock market index. The SOFIX is a large-cap index (if that is not an oxymoron in a tiny Eastern European market), but it does not take a genius to figure out that a strong euro means a strong SOFIX and vice versa, save for the 2008 crash, which was far more brutal for the local market.
This correlation is in big part because emerging markets borrow in U.S. dollars but repay their debts in local currencies. Every once in a while, as they have done recently, they overborrow and create the next emerging market crisis, as they cannot repay their debts.
Bulgaria is a fiscally conservative country, which is not something you can say about most of the rest of Europe. I don't really care for the "hard peg" to the euro. That hard peg can "go" in a difficult economic situation. Even though I rate the euro's chance of survival at no more than 50%, I would rather see them join the euro completely and eliminate the hard peg rather than stay in the present "currency purgatory."
Right next door, 45 minutes across the border in Turkey, the situation is out of control and feels like it is going to blow. The Turkish lira recently crossed five to the dollar and who knows where it will stop after falling from under 2:1 ($0.50) to over 5:1 ($0.20) in under five years. If the Fed does not stop tightening, which I don't think it will, I think we may end up having currency crises in Argentina, Turkey, and China at the same time, all due to years of rampant U.S. dollar borrowing to juice up economic returns.
Such dollar borrowing does nothing more than borrow from the future, creating a day of reckoning that seems to be up for some emerging markets.
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