Readers of our research know Assist FX has been relentlessly bearish the USD since early into 1Q2017. A plethora of recent rigorous internal research conducted in a new 2Q2018 updated assessment leads us to shift to a more complex position on USD: short-term bullish, medium-term neutral, long-term bearish.
It is no longer a high conviction directional play to sell dollars today and sell more tomorrow.
Ironically, fiscal irresponsibility in the US has triggered increased risks of a sudden shock move into USD in the near term due to its impact on global capital flows.
The narrative goes something like this: a combination of higher US sovereign credit risks, increased debt issuance, higher inflation, and a somewhat sloppy form of quicker nominal growth is placing immense underlying upward pressure on interest rates across the curve in the US. This triggers a bullhorn call from the Goldilocks Beach lifeguard team warning that the tide is about to recede deeply toward the ocean. Swimmers near the shore in the chilly water without bathing suits (per the well-known analogy made famous by Mr. Buffet) are increasingly likely to be “exposed” for swimming naked. What worked when central banks inspired yield chasers to keep rates much lower than they should have otherwise been won’t work when the bond bid disappears. It may be an unpleasant site for all if this leads to indecent exposure. Jittery capital has a tendency to rush out of EM quickly because it knows the EM exit ramp is quite narrow and prone to causing illiquidity. EM sovereigns with a high concentration of USD-based debt to GDP are those swimming closest to the shore.
Turkey, Indonesia, Argentina, Brazil, followed by several other household EM names are officially on notice. Seemingly attractive FX rates and EM fixed income are likely to become “much more attractive” before investors should consider parking capital in this space. EM names heavily tied to energy exports are positioned best to weather any storms as commodity prices remain very firm.
Concluding, risks are increasing for a rapid rush of capital out of low-quality EM and this could temporarily reverse or complicate the longer term trajectory of a weaker USD. Any market in or related to Turkey is the first priority to avoid. Those who celebrate Thanksgiving might even want to consider a replacement meal.