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At the beginning of 2018, global growth was firing on all fronts, and few would have thought that the tides would turn so quick. However, President Trump's rather unorthodox economic policies - from late-cycle fiscal policy to tariffs - have taken a toll on risk assets. The multi-year narrative of low volatility saw its end with the emergence of inflationary pressures within the U.S., causing the VIX to spike to 37 on February 5th and emerging markets and the S&P 500 to fall 12% and 10%, respectively, following the shock.
The main reasons for why these moves have materialized are the Federal Reserve's tightening of monetary policy and a stronger U.S. dollar. The greenback's 9% ascent has been a result of a dollar shortage in the offshore market due to the quantitative tightening process, which has left certain emerging markets that are encumbered with high amounts of dollar-denominated debt, destitute. The most obvious of these have been Turkey, Argentina, and Indonesia, whose central banks have engaged in unpopular tightening policies to avoid a balance of payments crisis.
Since then, the S&P has now made all-time highs, emerging markets have somewhat rebounded, and the dollar has corrected a little. This is where the confusion seems to be. With tariffs now beginning to take a toll on the global economy, and President Trump unapologetically announcing his disapproval of the Fed's hawkish stance, markets are unsure as to what the next moves will be. While the long-term trend seems to be in place, the 10-year yield and the dollar's recent moves seem to be pointing to a relief for risk assets in the short term. The safe havens - gold, the Swiss franc and the Japanese yen - seem to agree.
XAU, CHF, And JPY
The first question we should address is that of the "ultimate" safe haven to get a sense of what is most appropriate to look at for any market implications. Thankfully, it is not a difficult one to answer. In the past four recessions, JPY/CHF has rallied 63%, 34%, 22%, and 27% (Chart 1), while XAU/JPY has moved -24%, -28%, 4%, and -8% (Chart 2). The winner clearly seems to be JPY.
Both the Swiss and Japanese economies have similar backdrops, mainly of low inflationary pressures, which is why viewing them alongside an inflation hedge paints a clear picture as to what the current underlying economics is telling us. Both XAU/CHF and XAU/JPY are at a similar position.
This relationship makes sense. First of all, both gold and emerging markets are inextricably related to the dollar's strength. Secondly, gold can serve as a liquidity indicator, rising in times of dollar abundance, and declining in times of dearth. On the other side of this pair, the yen correlates negatively with emerging markets given its risk-off properties. A lower yen is also the primary driver of economic activity within Japan which fuels demand for imports, of which 61% come from neighboring Asian countries. In addition, the yen is a major funding currency, the weakness of which indicates that there is an abundance of carry trades, with capital is flowing into higher-yielding, riskier assets.
In the past two and a half years, XAU/JPY has been on an upward trend, making higher lows and being supported by a key trendline and higher global growth. This has been a decent indicator for rebounds in EM equities. The most recent uptick from that trendline suggests that a rebound could be imminent. Given the recent U.S. data, the U.S. Citigroup Economic Surprise Index has entered negative territory, which means that global growth could enter a phase of outperformance in the short term.
Recent data from emerging Asia is supportive of this view:
- Korean exports and imports grew annually by 6.2% and 16.2% in July;
- Singaporean retail sales grew by 2% at an annual pace in June;
- Singaporean non-oil exports increased by 11.8% annually in July, and core inflation climbed to 1.9%;
- Taiwanese industrial production is growing by 4.43% from a year earlier;
- Export orders by Taiwanese manufacturers grew by 8%, beating the consensus 3.3% figure, while Taiwanese imports grew by 20.5%;
- Filipino imports continue to grow at a stellar pace, at 24.2% annually in July, as part of Duterte's infrastructure program;
- Indonesian annual import and export growth came in at an impressive 31.56% and 19.33%, respectively;
- Malaysian trade also grew at a high rate.
The Japanese economy will likely see a short-lived upturn, driven by neighboring Asian growth. As global growth revives briefly, the yen may see a slight relapse. At the same time, short-term capital flows into riskier assets will relieve some of the boost that the dollar has been receiving, allowing gold to gain some traction. Powell's comments have also been material in driving down yields, which could have the effect of lowering real yields.
If we also look at XAU/CHF, we can see that it has a similar story (Chart 4). (Source: TradingView)
Gold in franc terms has hit a key technical point, which is poised for a rebound. The franc additionally has some of its own dynamics, which will play out in the near future.
Aside from the carry trade story, CHF has appreciated substantially due to Italian, Turkish, and Argentinian stress. Inflation is still a disappointing 1.2%, while core inflation is a meager 0.5%, so the SNB will need to step in sooner than later to stop this appreciation from going any further. The SNB has been adamant in opinionating their view on the "overvalued" CHF on a steady basis. Even when EUR/CHF climbed to nearly 1.20 at the end of April, the SNB still determined the weakened CHF as "highly valued". It is only a matter of time that the SNB intervenes to stabilize macroeconomic conditions. Trend reversals in these three safe havens also coincide with trend reversals in the most important currency right now: the yuan (Chart 5). (Source: TradingView)
A depreciating yuan is also accompanied by a decline in gold prices relative to all currencies, which is likely due to: a stronger dollar environment, and a stronger growth environment where gold performs poorly. After the depreciation has run its course, it is likely that the cyclical effects of an upturn in mean-reverting series such as PMIs and economic surprise indexes complete their cycle, prompting a reversal of the short-term upward trend. This trend is likely reversing now. Obviously, however, the strongest factor of this argument is the fact that the PBoC's depreciation is most likely at its nadir, as further depreciation could trigger a vicious loop of capital flight and further depreciation - an event that Chinese officials are all too familiar with. Any country would want to avoid such a fate, but the case for China is special since they need open and free movement of capital in order to achieve their goal of a global power. The reversal in the renminbi is therefore also likely to lead to a rebound in gold prices and a slight weakness in the dollar, which will be a positive development for emerging markets, at least in the short term.
China's Golden Strategy
China's progression to the world's most influential economy is a function of a myriad strategies. One of these strategies is its accumulation of gold reserves to diversify its foreign exchange holdings. Although its foreign exchange reserve composition is a state secret, its pattern of gold purchases is not (Chart 6).
Each major purchase of gold after a large fall in prices has coincided with the initiation of rate hikes by the Federal Reserve. While prices have not yet corrected by nearly as much as the average decline before the PBoC makes its purchases, the concomitant decline of both the yuan and gold has limited the volatility of gold prices in yuan terms (Chart 7). (Source: TradingView)
Whether this has been engineered by the PBoC is unknown, but limiting this volatility could be a ploy to restrain the fluctuation of the value of its FX reserves.
The commodity market is essential to look at to get a sense of China's economic health. As a major element of China's industrial economy, copper is a reliable barometer of China's strength. While Xi Jinping's most recent commitment to deleverage and clean up the economy has been a factor in placing substantial anxiety in emerging markets, the onset of tariffs has led to a reversal in policy by the PBoC. While gold has suffered, copper has suffered even more, bringing the copper/gold ratio to a support level, putting forward the possibility of a resurging demand for copper in the near future on the back of lower copper prices, consistent with China's most recent policy shift. This also would provide a support for emerging markets, as the correlation between copper in yuan terms and relative performance of EEM/SPX shows (Chart 8). (Source: TradingView)
To further add fuel to the fire, the relative performance of emerging markets and U.S. equities is also at a support level that has previously indicated rebounds.
XAU And The Real FFR
Out of all the safe havens, gold has possessed the ability to harbor safe haven flows over the longest span of time. The precious commodity's role stems from two major motives: its historic function as a currency's base value; and as a substitute asset for low rates of return. In a fiat world, the former has obviously lost its direct value, however, the psychological factor still stands; and with the Federal Reserve now hiking interest rates close to the inflation rate, investors have little reason to buy the yellow metal for higher rates of return.
Gold prices increase in congruence with increasing TIPS prices and declining real yields (which are two sides of the same coin). However, there emerged a dissidence between the bond market and the commodity market as to whether inflation was materializing meaningfully at the beginning of this year, and the historical relationship between TIPS prices and gold broke down (Chart 9). (Source: TradingView)
While gold was implying that the Fed was behind the curve, the bond market was announcing a truly tight monetary policy.
Not long after, we saw an underperformance of the global economy relative to the U.S. economy, an average hourly earnings reading which confirmed the realization of inflation, and the VIX spike which broke the low-volatility narrative, possibly the effects of quantitative tightening on market participants, and the Fed's reaction to fiscal policy. Expectations of the Fed hiking increased, the dollar saw increased inflows, and gold caught up with the reality - that the yellow metal cannot rally alongside a strong greenback.
The relationship has now re-asserted itself, but the next move is a big question mark. Whether gold moves up or down is a function of what real yields (and therefore, the dollar) will do.
Inflationary pressures across the globe are rising, as the global economy seems to be entering a late-cycle phase. Where this was most apparent was in Canada, where inflation has reached 3% - and even core measures are above 2%. Even in Japan and Switzerland, inflation has risen, albeit not to levels which are deemed satisfactory.
There are many other metrics with which one can confirm the existence of late-cycle phenomenon: The outperformance of growth stocks relative to value stocks; the incredibly tight labor market across the developed world; the normalization of monetary policy across both the developed and emerging world; etc. While the evidence of inflation is seemingly endless, the question now seems to be which direction the Federal Reserve will direct yields.
Theoretically, a central bank should not be too concerned with the performance of the global economy, and definitely not the President's opinions. Unless there is a large market move, like the Asian Financial Crisis of 1997 which disrupted the Fed's tightening cycle, the Fed should be concerned with the U.S. only - to guarantee the allure of independence. But his reserved remarks about inflation at the Jackson Hole Symposium did have an impact on markets. Powell alluded to the FOMC's slight shift in the inflation target to "symmetric" of around 2% from the May monetary policy statement, stating that "we have no clear sign of an acceleration above 2 per cent", which fed into the dollar's retrenchment.
Interestingly, this comes alongside the PBoC's re-introduction of the "counter-cyclical adjustment factor" (CCAF) to guard against what some Chinese authorities have criticized as irrational market moves. This is also likely to have taken place to avoid the appreciation of USD/CNY past the psychological level of 6.95. It is possible that the lows reached following the tariffs of just below 6.95 may be deemed an equilibrium value by markets, as an appreciation past that could be construed as capital flight. The last time the PBoC introduced the CCAF, the CNY subsequently appreciated 7%, then another 3% after a brief relapse.
In addition to all of this, the Treasury-Bund spread has tightened, and the Japanese 10/2 yield curve has steepened relative to the U.S. one. This relief in diverging rate differentials will take some pressure off the dollar and could provide some support for risk assets in the near term. Furthermore, both U.S. Treasuries and the dollar are positioned with extreme short and long speculative positions, which are set up for a pullback.
Recent data is also indicating a slight slowdown in the U.S. economy, a likely effect of tariffs. Both the ISM and PMIs have begun to roll over, in line with tightening financial conditions, and durable goods orders also contracted by 1.7% in July.
Given all this, it is likely that Powell has downplayed the current growth positioning of the U.S. economy to loosen some of the strings that hold the economy together. This will ultimately mean lower real rates, a lower dollar, and higher gold prices in the short term, before growth and inflation are given another boost before the dollar bull market resumes.
But just how much will the dollar decline by? If we look at short-term technicals, we can make some inferences on short-term movements. Chart 10 shows a Fibonacci retracement of 38.6% is next on the horizon, giving the DXY Index a target value of 93.66, 1.5% below current levels, equivalent to an increase in EEM of 4.6% to 45.38, and gold to 1240. (Source: TradingView)
However, the reasons that this is only a short-term reversal are plentiful. The Fed has been careful this year in ensuring that its cogitations are well-heard by pundits. For the most part, the Fed has played up its intentions to tighten policy, even successfully fomenting an additional rate hike for this year into market pricing. After all, this makes sense. Not only is the labor market incredibly tight, with the unemployment rate 0.65% below the NAIRU, but inflation is already above 2%. In addition to this are the Trump administration's enormous fiscal stimulus, estimated to yield 1-2% of GDP in fiscal thrust over the next decade, which is in the latter part of this business cycle, and the Fed's quantitative tightening program, which is sucking up dollars from the economy. These factors are incredibly bullish for the dollar.
However, President Trump is currently not the biggest fan of the Fed's hawkishness or the dollar's strength. But the President is certainly not in the Fed's reaction function; Governor Powell is unlikely - as he should be - to react to Trump's dribbling. But that is not to say that the President has not had a meaningful impact on markets. Table 1 shows the daily move in the DXY, the 10-year yield and the S&P 500 on the days Trump, Navarro, Mnuchin or Kudlow made any comments on the dollar.
(Source: Calculations done by author; based on adding/subtracting the daily effect of comments on the dollar made by White House officials)
Summing and averaging both positive and negative comments relating to the dollar by the President and his staff, we can see that the impact on the 10-year yield and the U.S. dollar has been particularly meaningful. Some interesting conclusions can be drawn from this table:
1. Firstly, markets do not seem to buy any "positive" comments. Both the yield and the dollar have seemed to decline, both as a sum and on average, on any negative or positive statements. This may be related to the fact that markets are aware of the White House's genuine distaste of a strong dollar. The skewed reaction towards negative comments can also be seen by the White House's almost comedic lack of communication. The flip-flopping between positive and negative comments merely months apart may cause market participants to brush off the "strong dollar" comments as noise.
2. Secondly, the net effect on the S&P has been 0. Both the actual net impact and the individual impact are marginal (40 bps). This is likely due to an indirect effect of the currency on the stock market.
3. In addition, had it not been for Trump's negative comments, the DXY could have potentially been almost 5% higher than it is today - which means it would be at 100 (Chart 11). Similarly, the 10-year yield would have also been around 14 bps higher, i.e. close to 3%. (Source: Currency data from Investing.com; Calculations done by author; based on adding/subtracting the daily effect of comments on the dollar made by White House officials)
4. The implications of this are interesting, albeit a little confusing. While this could mean that the President has potentially succeeded in capping the dollar's upward moves, thereby fulfilling his mercantilist philosophy, this could also have been a blessing in disguise for emerging markets, as a DXY rally to 100 could have been catastrophic. Certainly, if we follow this logic, we can extrapolate long-term fair values of currencies based on this hypothesis that President Trump's distorting remarks on the dollar had a serious effect on certain financial assets. Appropriately assuming that markets have priced - or eventually will price - the dollar according to fundamentals, we can factor out Trump's remarks as noise to movements of currencies. We can see that most would have been weaker against the dollar for the most part were it not for the President's comments (Table 2).
(Source: Currency data from Investing.com; Calculations done by author; based on adding/subtracting the daily effect of comments on the dollar made by White House officials)
What really jumps out immediately is the fair value of the euro, which is at an astonishing 1.10. It seems that President Trump has in fact successfully disallowed the euro from gaining any further competitive advantage. This has further important implications, as it may have prompted the ECB to be less hawkish than it ought to have been, but on the other hand, potentially disallowed the euro area to fully offset the effects of tariffs and a growth slowdown. In addition, given the euro's higher beta to the dollar, it would have depreciated more than all its other crosses, which may have also spared other neighboring European economies the need to tilt further on the dovish side (this is particularly the case for the Riksbank which has been unsatisfied of how easy monetary conditions are in Sweden). Where this is most evident is in the implied fair value of EUR/CHF (1.10), which would certainly have triggered some sort of response by the SNB. Almost all emerging markets seem to have been spared further turmoil thanks to Trump. In China's case, had it not been for President Trump's negative comment, a rally to 100 for the DXY could have catalyzed an appreciation of USD/CNY to past 7, which would have been particularly detrimental for its capital flows. An increase to 100 in the DXY, alongside higher 10-year yields would certainly have spelled doom for emerging economies sooner than we would have thought.
The short-term cycle is having some effects on the U.S. economy, which can be observed through recently disappointing data. This is likely to cause some important reversals in the safe haven space, which has some important implications for risk assets.
However, the long-term trend of the dollar is intact due to the removal of dollars from circulation and the likely inflationary impact of late-cycle fiscal stimulus. The Fed is unlikely to budge from its hawkishness based on the President's opinions or slight turmoil in the rest of the world.
Disclosure: I am/we are long GLD. 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.