Badly Misled

There once was a theory that said
QE would prevent further dread
Of financial mayhem
From p.m. to a.m.
Alas we’ve been badly misled

Reality has now showcased
That faith here was somewhat misplaced
Thus markets worldwide
Are starting to slide
While Janet and Ben are disgraced

The human brain is a funny thing. One of its key features is its propensity to search for patterns in potentially random data. But even keeping that in mind, I cannot help but notice a pattern of market jitters across an increasing number of markets.

When the Argentine peso started falling sharply earlier this year (-47% YTD), it was seen as an idiosyncratic response to locally grown problems. After all, the financial situation in that country has been dire for years. When the Turkish lira started falling sharply a few months later (-22% YTD), it was attributed to concerns over the central bank’s diminishing independence in the face of pressure from Turkish President Erdogan. Again, this was seen as country specific and not part of a trend. Traders then noticed that the Brazilian real was seriously underperforming (-18.8% YTD), and it was chalked up to concerns over the upcoming election and ongoing economic malaise. But then the Mexican peso, which had rallied sharply at the beginning of the year, turned tail in April and has fallen more than 11% since then. Of course, this was chalked up to NAFTA and trade issues as well as the seeming certainty that AMLO, a left-wing populist firebrand, will be the next president of the country.

Pivoting to Asia we have started to see sharper declines in the Indian rupee, historically a much less volatile currency than those mentioned above, but now down -6.3% YTD and trading at a new historically low level. Indonesia? The rupiyah is down 8% YTD having fallen 4% in just the past three weeks. Thailand? Similar to Mexico, after a solid Q1 performance, it has fallen 6.2% in Q2 and is now lower by 3% on the year. And of course there is the Chinese yuan, which fell a further 0.3% overnight taking its YTD loss to 1.7%, but its Q2 performance to -6.0%.
This laundry list of currencies that have been under pressure is hardly exhaustive, but merely shown to demonstrate that this is not random data, but an actual pattern. And what is the common denominator for all these countries? Each one of them saw massive investment inflows over the past ten years as the Fed, ECB, BOJ, BOE, BOC and SNB, to name but a few, all massively expanded their balance sheets while driving longer term interest rates lower in an effort to help support their respective economies. In other words, they were all proponents of QE.

QE was always suspect as during the actual asset purchase stages, the central banks explained that the flow of purchases was the key feature of the process that would help improve economic outcomes. However, when they stopped buying assets (although not all of them have) they explained that it was still good because it was the stock of assets they had already purchased that was the important feature helping to improve economic outcomes. And then, when the Fed could no longer countenance the idea that QE was critical, given the US economy’s strong performance, they told us that reducing the balance sheet was merely background noise, “like paint drying” according to then Fed Chair Yellen, and would have no impact at all on markets or the economy. Now I don’t know about you, but this messaging never really made sense. How is it possible that expanding the Fed’s balance sheet >$3 trillion of assets would help the economy, but that contracting the balance sheet would have no impact?

Well, folks, we are witnessing that impact every day now. Whether it’s the Shanghai stock market, down more than 20% since January, or all of the currencies listed above, or rising bond yields across the entire emerging market space, the market somnolence calm that had prevailed for much of the past decade seems well and truly over. And not only that, this process is really just beginning. Market turbulence is going to be the new normal. And I assure you, this is entirely the result of QE, an emergency measure that morphed into central bankers’ favorite and most widely used tool for all occasions.

The point of all this is to remind you that volatility is neither unprecedented nor unusual when it comes to currency markets. In fact, prior to the financial crisis in 2008-9, it was the norm. And so those of you charged with hedging FX exposures need to keep on top of your programs, they are going to be crucial in mitigating earnings volatility going forward.

Please excuse my rant, but every once in a while things just pile up and need to be vented! Turning to the overnight markets, the dollar has actually had a mixed session, e.g. gaining vs. the pound but falling vs. the euro. However, this session follows yesterday’s NY trading which saw the dollar rally across the board. Ultimately, the central banks continue to maintain an outsized impact on the currency markets, and none of them are about to change their current policy trajectories. So a tighter Fed moving much faster than every other central bank means that the dollar will remain supported as we go forward. The question is more how far it will rally rather than if it will rally.

As to today’s data, we see the third reading of Q1 GDP (exp 2.2%) as well as Initial Claims (220K). Two Fed speakers, Bostic and Bullard, add to the mix, but given that the data has remained consistently upbeat in the US, it seems unlikely that they are going to change their tune very much. Instead, the big picture remains the same, broad dollar strength amid more volatile markets, but given recent price action and dollar strength, a mild dollar correction today doesn’t seem a bad bet.

Good luck

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