USD Soft Patch to Set the Stage for Another Grind Higher in Asset Prices and Interest Rates

  • Bullish USD sentiment clearly became overly reliant on the Trump Administration’s desired agenda of tax cuts, deregulation, and infrastructure.
  • Due to the host of potential political scandals plaguing the Administration, as well as general political dysfunction in the US Congress, expectations of a pro-growth agenda being enacted this year have been significantly muted, though not completely discounted by Assist FX.
  • Assist FX still sees passage of a lighter version of market-friendly reforms in 4Q2017/1Q2018 limping past the finish line in what is becoming a non-consensus call. Sparring blocs within the Republican party will increase cooperation as political viability becomes increasingly threatened for the 2018 midterm elections.
  • In the near term, USD will struggle to stage sustainable rallies as political uncertainty takes its toll.
  • As financial asset prices in equities, real estate, and alternatives continue to inflate further into historically stretched valuation territory, it will place pressure on the Fed to remain on track for gradual rate hikes approximately once per quarter.
  • Long duration USTs will be pressured by lower real yields, lifting rates at the long end of the curve. This will contribute to moderate firming in USD in the medium term 3-6 month outlook.
  • Top risks to this view include a pronounced spillover effect from China’s debt deleveraging efforts resulting in global financial market instability, as well as any number of potential Trump Administration scandals escalating to such severity that the blow-back shifts the political landscape in favor of left leaning populists for 2018 and beyond. While these risks are currently underappreciated by markets, they are not our base case.

China’s Controlled Deleveraging

  • China has decided it is time to pull away the punch bowl for a little while.
  • There is a coordinated series of moves by China’s leadership to slow down the risk buildup posed by excess leverage.
  • The correction in both Chinese bonds and equities has thus far been met primarily with utter disinterest by advanced economy risk markets. Volatility levels are still crawling near historic lows across major asset classes and new all time highs are regularly being surpassed.
  • Still, if there is anything posing an out-sized share of global systemic risk it is China’s massive debt load.
  • Keep an eye on raw commodity prices in China as a leading proxy for  inflationary/deflationary asset price impulses. Iron ore specifically has had difficulties stabilizing as the Q4 2016 run up is moving closer to being fully erased on the way back down.
  • My base case is that China is not yet ready to unravel and this is a healthy process of mild deleveraging. However, it won’t take many more risk off days in China before it begins to spill over into developed markets elsewhere. If this situation does not materialize with increased stabilization by the middle of next week, there will be a tradable risk off wave. Stay tuned.

iron ore 051217

overnight shibor 051117

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Do Words Trump the Data? Probably Not Yet

“Our companies can’t compete with them now because our currency is too strong. And it’s killing us,” Trump told The Journal, referring to competition from China.

The Trump Administration wants to make America great again by transforming it into a manufacturing powerhouse like it was in the Post War glory days. Buy America, hire America. That’s not so bad really. Most Americans are generally on board with this patriotic slogan as long as its implications stop there. But then Mr. Trump takes things a step further with nonsense about the “strong dollar killing us.” By “us,” he means the 13% of the US economy reliant upon goods exports (as opposed to the other 87% more reliant upon domestic services and consumption). Mr. Trump surely isn’t referring to the more than 97% of Americans whose incomes are gained in dollars and whose spending power declines when the dollar’s does.

It is true that, in the near term, sharp increases in the dollar’s value can cause financial instability as foreign debtors struggle to pay back loans denominated in a strengthening currency relative to their own. It also causes the perception of lower US multinational corporate earnings as a portion of overseas earnings in relatively weaker currencies get converted back into stronger dollars at a lower nominal value on the income statement. This is as much a perception as anything because the same relatively stronger dollars that make foreign earnings look lower also have more purchasing power to lower future costs in those same regions.

In the medium to long term, there is absolutely no doubt that a strong domestic currency is in the interest of not just the citizens sharing it, but real GDP as well. Inflation tends to be lower, real incomes tend to be higher, and overall well-being tends to be notably higher in countries with strong currencies and low inflation. This fact has also been the stance of the United States Treasury for several decades. Is Mr. Trump challenging this stance or is he simply using fighting words to get in front of China (or others potentially) before it might need to devalue the yuan? Does he want to be able to say “told you so” if and when the yuan gets devalued with the intention of gaining enough political capital to impose tariffs against China? Who knows. It isn’t heartening that Mr. Trump doesn’t seem to understand how China is actually burning through currency reserves to prop up the value of its currency rather than hold it down as he alleges.

It comes down to this: will market sentiment return to favoring the dollar when US economic data surpasses expectations or have Trump Administration words materially damaged the perception of the long standing King Dollar policy in a way that it outweighs the data? Assist FX sees a continuation of data dependent sentiment for the dollar unless the Trump Administration makes an official move to target “currency manipulation” of trading partners using an executive order or proposed legislation. Markets are hyper-sensitive to Trump Administration commentary right now given all of the actions taken already in the first couple of weeks of its existence but the data will eventually move back into the driver’s seat.

Watch Out for These Two Macro Risks

If you must limit yourself to only two macro risks worthy of flaring up your insomnia they are these:

1.) Trade war contagion – Globalization and open borders are going out of style in mainstream developed market politics. Fast. In theory, trade reform can be targeted to narrow trade deficits, increase wages for the middle class, and make every developed country great again. In reality, there are tremendous risks of unintended consequences shaking the foundation of modern global economies. Modern economies function with tightly intertwined international supply chains. What would happen if every US import from Mexico, China, or even Germany rose in price by 15-20% at the stroke of a legislative pen? Would it really stop there? Would it not spark a wave of race-to-the-bottom retaliations, currency devaluations, and nasty inflation eroding real incomes across the board?  This is the top known economic and market risk as 2017 swings into gear. Pay attention to statements of pre-retaliation by public officials in trade-dominated economies.

2.) China’s currency reserves burn rate – China is burning through reserves at an alarming rate to prop up the yuan rather than suppressing it for competitive purposes as commonly alluded to by US President Trump. It has depleted more than 25% of its currency reserves in the past 1 1/2 years. It may only have another 6-18 months left before it is forced into a massive yuan devaluation of at least 15% to stop the bleeding. This would increase pressure on other Asian economies to also devalue their currencies, inflict trauma on US exporters and multinationals, compound default risk for dollar-denominated debtors, and destabilize financial markets. Imagine the turbulence seen in August of 2015 multiplied by at least 10; then tack on second-round effect multipliers. It is certainly worthy of being on the top macro risk short list.

Honorable mention goes to political election risk in the Eurozone this year. This will be a topic covered in more detail on this site in the future.