For everyone who seems to think
The dollar will steadily sink
This weekend disclosed
The world is opposed
To letting the buck’s value shrink
In China they eased the restrictions
On short sales in all jurisdictions
While Europe explained
QE’s not constrained
And further rate cuts are not fictions
It cannot be a surprise that we are beginning to see a more concerted response to dollar weakness from major central banks. As I have written consistently, at the current time, no nation wants their currency to be strong. Each is convinced that a weak currency will help obtain the twin goals of improved export performance leading to economic growth and higher inflation. While financial theory does show that, in a closed system, those are two natural consequences of a weak currency, the evidence over the past twelve years has been less convincing. Of course, as with every economic theory, a key assumption is ‘ceteris paribus’ or all else being equal. But all else is never equal. A strong argument can be made that in addition to the global recession undermining pricing power, the world is in the midst of a debt deflation. This is the situation where a high and rising level of overall debt outstanding directs cash flow to repayment and reduces the available funding for other economic activity. That missing demand results in price declines and hence, the debt deflation. History has shown a strong correlation between high levels of debt and deflation, something many observers fail to recognize.
However, central banks, as with most large institutions, are always fighting the last war. The central bank playbook, which had been effective from Bretton Woods, in 1944 until, arguably, sometime just before the Great Financial Crisis in 2008-09, explained that the reflexive response to economic weakness was to cut interest rates and ease financing conditions. This would have the dual effect of encouraging borrowing for more activity while at the same time weakening the currency and making the export community more competitive internationally, thus boosting growth further. And finally, a weaker currency would result in imported inflation, as importers would be forced to raise prices.
The Great Financial Crisis, though, essentially broke that model, as both the economic and market responses to central bank activities did not fit that theoretical framework. Instead, adhering to the playbook saw interest rates cut to zero, and then below zero throughout Europe and Japan, additional policy ease via QE and yet still extremely modest economic activity. And, perhaps, that was the problem. Every central bank enacted their policies at the same time, thus there was no large relative change in policy. After all, if every central bank cut interest rates, then the theoretical positive outcomes are negated. In other words, ceteris isn’t paribus.
Alas, central banks have proven they are incapable of independent thought, and they have been acting in concert ever since. Thus, rate cuts by one beget rate cuts by another, sometimes explicitly (Denmark and Switzerland cutting rates after the ECB acts) and sometimes implicitly (the ECB, BOE and BOC cutting rates after the Fed acts). In the end, the results are that the relative policy settings remain very close to unchanged and thus, the only beneficiary is the equity market, where all that excess money eventually flows in the great hunt for positive returns.
Keeping the central bank mindset at the fore, we have an easy time understanding the weekend actions and comments from the PBOC and the ECB. The PBOC adjusted a reserve policy that had been aimed at preventing rampant selling speculation against the renminbi. For the past two plus years, all Chinese banks had been required to keep a 20% reserve against any short forward CNY positions they executed on behalf of customers. This made shorting CNY prohibitively expensive, thus reducing the incentive to do so and helped support the currency. However, the recent price action in CNY has been strongly positive, with the renminbi having appreciated nearly 7% between late May and Friday. For a country like China, that sells a great many low margin products to the rest of the world, a strong currency is a clear impediment to their economic plans. The PBOC action this weekend, removing that reserve requirement completely, is perfectly in keeping with the mindset of a weaker currency will help support exports and by extension economic growth. Now there is no penalty to short CNY, so you can expect more traders to do so. Especially since the fixing last night was at a weaker CNY level than expected by the market. Look for further CNY (-0.8% overnight) weakness going forward.
As to the ECB, their actions were less concrete, but no less real. ECB Chief Economist Philip Lane, the member with the most respected policy chops, was on the tape explaining that the Eurozone faces a rocky patch after the initial rebound from Covid. He added, “I do not see that the ECB has a structurally tighter orientation for monetary policy[than the Federal Reserve]. Anyone who pays attention to our policies and forward guidance knows that we will not tighten policy without inflation solidly appearing in the data.” Lastly, he indicated that both scaling up QE purchases and further rate cuts are on the table.
Again, it should be no surprise that the ECB is unwilling to allow the euro to simply rally unabated in the current environment. The playbook is clear, a strong currency needs to be addressed, i.e. weakened. This weekend simply demonstrated that all the major central banks view the world in exactly the same manner.
Turning to the markets on this holiday-shortened session, we see that Chinese equities were huge beneficiaries of the PBOC action with Shanghai (+2.65%) and the Hang Seng (+2.0%) both strongly higher although the Nikkei (-0.25%) did not share the market’s enthusiasm. European markets are firming up as I type, overcoming some early weakness and now green across the board. So, while the FTSE 100 (+0.1%) is the laggard, both the DAX (+0.45%) and CAC (+0.75%) are starting to make some nice gains. As to US futures, they, too, are now all in the green with NASDAQ (+ 1.3%) far and away the leader. Despite the federal holiday in the US, the stock market is, in fact, open today.
Banks, however, are closed and the Treasury market is closed with them. So, while there is no movement there, we are seeing ongoing buying interest across the European government bond markets as traders prepare for increased ECB QE activity. After all, if banks don’t own the bonds the ECB wants to buy, they will not be able to mark them up and sell them to the only price insensitive buyer in the European government bond market. So, yields here are lower by about 1 basis point across the board.
As to the dollar, it is broadly, but mildly stronger this morning. Only the yen (-0.15%) is weaker in the G10 space as the rest of the block is responding to the belief that all the central banks are going to loosen policy further, a la the ECB. As to the EMG bloc, CZK is actually the biggest loser, falling 0.9% after CPI there surprised the market by falling slightly, to 3.2%, rather than extending its recent string of gains. This has the market looking for further central bank ease going forward, something that had been questioned as CPI rose. Otherwise, as we see the prices of both oil and gold decline, we are seeing MXN (-0.6%), ZAR (-0.5%) and RUB (-0.5%) all fall in line. On the flip side, only KRW (+0.55%) has shown any strength as foreign investors continue to pile into the stock market there on the back of Chinese hopes.
We do get some important data this week as follows:
|Tuesday||CPI||0.2% (1.4% Y/Y)|
|-ex food & energy||0.2% (1.7% Y/Y)|
|Wednesday||PPI||0.2% (0.2% Y/Y)|
|-ex food & energy||0.2% (0.9% Y/Y)|
Remember, we have seen five consecutive higher than expected CPI prints, so there will be a lot of scrutiny there, but ultimately, the data continues to point to a slowing recovery with job growth still a major problem. We also hear from nine more Fed speakers, but again, this message is already clear, ZIRP forever and Congress needs to pass stimulus.
In the end, I find no case for the dollar to weaken appreciably from current levels, and expect that if anything, modest strength is the most likely path going forward, at least until the election.
Good luck and stay safe