It’s Just Not True

Chair Powell said it’s just not true
That all of the things that we do
Impact EMG
Instead what we see
Is our actions hardly pass through

Price volatility throughout the emerging markets continues to be one of the dominant discussions amongst traders and investors. But interestingly that discussion has now spread to central bankers as well. Early this morning Chair Powell, in a speech in Zurich, tried to explain that Fed policy is not a very big driver of market activity in the EMG space, although there have been instances in the past where that seemed to be the case, notably the Taper Tantrum in 2013. However, looking at his charts and listening to him, I was not really convinced. Certainly my observation from a long career in the markets is that Fed policy impacts every other country, just some more than others. Interestingly, yesterday the economists at the San Francisco Fed released a paper saying that FOMC policies clearly had an impact on other economies, with the biggest impact on those economies that run large current account deficits. Now that is research that I can appreciate as it coincides with my (and many other) observations over time. In fact, I wrote about this just yesterday and this has been a common theme amongst many analysts. In the end, the market didn’t seem to pay too much attention to Powell’s speech.

The President’s soon to decide
If sanctions will be reapplied
On oil from Iran
Imposing a ban
And impacting prices worldwide

The other key story in the market this morning is the imminent decision from the White House on whether the US will be exiting the Iran nuclear deal and potentially reimposing sanctions on Iranian companies. If the US does exit the deal, it is expected to result in a reduction of Iranian oil exports of approximately 500K bbl/day, a pretty significant amount, although not enough to cripple supply. Remember, oil prices have risen >10% in the past month as this process has evolved and it is a fair question to ask whether or not we have seen the worst already. However, the overall uncertainty has been a definite issue for the market, and while the oil price might have already adjusted, it is likely there will be knock-on effects in other markets, as well as on the prices of specific companies who benefitted from the reengagement with Iran. The point is that we have the opportunity for another volatility inducing event occurring in the near future which means that havens are likely to perform well today.

Which brings us to the dollar and its recent activity. One of the key features we have seen lately has been the dollar’s ongoing rebound after last year’s weakness. In fact, the euro is now trading below 1.1900 this morning, which is its lowest level this year. The pound, too, is back to its YTD lows, although hasn’t broken through those levels yet, and only the yen has not yet ceded all its gains for the year. Of course, given the yen’s status as a safe haven currency, it should be no surprise that it has outperformed the other two major currencies. The question really is can this dollar rally continue, and if so, how much farther can it go?

At this point you all know that I believe the dollar has further to rally. It has become abundantly clear that the US economy continues to lead the way forward as much of the rest of the developed world has seen a trend of slowing growth develop. Meanwhile, there is absolutely no indication that the FOMC is going to change its current plan, of at least two more rate hikes this year alongside the continued reduction in the size of its balance sheet. In fact, though a number of Fed speakers (most recently, Atlanta’s Bostic) have been clear that they are comfortable with some overshoot in inflation, that comfort is likely to have limits. It remains difficult for me to see the Fed passing off, say, 2.5% inflation as unconcerning, certainly not based on the more hawkish makeup of the current voters. Given that background, and the fact that the correlation between US interest rates and the dollar has reasserted itself of late, I continue to see higher rates in the US and a stronger dollar. We will need to see either a reversal of the slowing growth data elsewhere or a significant turn lower in the US data to change this trend. Right now, neither seems likely, but given the uncertainty created by the current administration’s policies, anything is possible.

So looking at the overnight activity, the dollar continues to rally. This morning it is higher by 0.4% vs. the euro, 0.3% vs. the pound and 0.8% vs. the Australian dollar. A quick look at the overnight data shows Japanese household spending to have been a disappointment in March, actually falling -0.1% rather than rising the expected 0.7%. Australian Retail Sales were disappointingly flat, undermining the Aussie. Halifax House prices in the UK fell -3.1% in April, much more than expected, which can be seen in the pound’s weakness, while from the Eurozone, German IP rose 1.0%, pretty much as expected, and not nearly enough to change the recent trend of weaker data from the continent.

Remember, too, that market positioning shows speculative dollar shorts are still quite large and while they have been reduced lately, still have much further to go. This means that there is going to be a natural bid for the dollar for a while yet unless the data turns abruptly. In fact, my take is that we will continue to see the dollar outperform almost all other currencies until at least the middle of summer, at which point the specs are likely to be square.

I understand the structural issues that are going to weigh on the dollar in the longer term, but there is no indication those are going to make themselves felt in the near future. Rather, the current trend is quite strong and growing stronger, and as such, barring something truly dramatic from the US (a collapse in data or an about face from the Fed) I see the dollar continuing along its merry way. Is my year-end forecast of 1.05 for the euro really out of court? Right now it doesn’t seem so!

Good luck