Their Siren Song

The trend ‘gainst the dollar is strong
With bears playing their siren song
As long as real rates
Are in dire straits
‘Twould be a mistake to go long

While there is usually some interesting tidbit on which to focus regarding market behavior that is not specifically FX related, this morning that does not seem to be the case. In fact, today’s most noteworthy story is that the dollar continues to drive lower vs. almost all its counterparts. As there was no specific news or data that appears to be driving other currencies higher, I can only attribute this broad resumption of the dollar downtrend to the fact that real interest rates in the US have turned back lower.

Looking back a few weeks, 10-year US real interest rates (nominal – CPI) bottomed at -1.08% on August 6th. That coincided with the peak price in gold, as well as the euro’s local high. But then Treasury yields began to back up as the bond market started getting indigestion from the Treasury issuance schedule ($316 billion total since then, of which $112 billion were Notes and Bonds.) The problem is that not merely is the size of the issuance unprecedented, but that it shows no signs of slowing down as the government continues to run massive deficits.

At any rate, real yields backed up by 14 basis points in the ensuing week, which resulted in both a sharp correction in the price of gold, and support for the dollar. But it seems that phase of the market may be behind us as Treasury yields have been sliding on both a nominal and real basis, and we have seen gold (and silver) recoup those losses while the dollar has ceded its gains and then some.

At this point, the question becomes, what is driving real yields? Is it fears of rising inflation? Is it hope that the Fed will maintain ultra-easy monetary policy even if the economy recovers strongly? Or is it something else?

Regarding the pace of inflation, while last week’s CPI data was certainly a shock to most eyes, it doesn’t seem as though it is the driver. I only point this out because the nadir in real yields occurred a week before the CPI data was released. Now it is certainly possible that bond investors were anticipating a higher inflation print, but there was absolutely no indication it would be as high as it turned out to be. In fact, based on the CPI release, I would have anticipated real yields to fall further, as the combination of higher inflation and a Fed that is essentially ignoring inflation at the current time is a recipe for further declines there. Remember, everything we have heard from the Fed is that not merely are they unconcerned with inflation, but that they welcome it and are comfortable allowing it to run hotter than their target for a time going forward.

This latter commentary implies that there is not going to be any change in the Fed’s policy stance in the near future either. Rather, Chairman Powell has made it clear that the Fed is going to provide ongoing support and liquidity to the markets economy for as long as they deem it necessary. Oh, and by the way, they have plenty of tools left with which to do so.

If these are not viable explanations for the change in trend, one other possible driver is the vagaries of the ongoing pandemic. Perhaps there is a relationship between increases in infection rates and investor assessments of the future. Logically, that would not be far-fetched, and there is growing evidence that there is a correlation between market behavior and covid news. Specifically, when it appears that covid is in retreat, bond yields tend to rise, and so real rates have been moving in lockstep. As well, when the news indicates that the virus is resurgent, the yield complex tends to head lower. Thus, in a convoluted way, perhaps the dollar bearishness that has become so pervasive is being driven by the idea that the US continues to suffer the most from Covid-19, and as long as that remains the case, this trend will remain intact.

Now, I would not want to base all my trading and hedging decisions on this idea, but it is certainly worth keeping in mind when looking at short-term risk exposures and potential timing to manage them.

But as I said at the top, overall, there is very little of note in the financial press and not surprisingly, market activity has been fairly muted. For example, equity markets in Asia basically finished either side of unchanged on the day (Nikkei -0.2%, Hang Seng +0.1%, Shanghai +0.3%). Europe, which had been largely unchanged all morning has been on a late run and is now nicely higher (DAX +0.9%, CAC +0.6%) and US futures have also edged up from earlier unchanged levels. As discussed, Treasury yields continue to drift lower (-1.5 basis points) and gold is rocking (+1.0% and back over $2000/oz.)

And the dollar? Well, it is definitely on its back foot this morning, with the entire G10 complex firmer led by GBP (+0.5%) on the strength of optimism over the resumption of Brexit talks and JPY (+0.45%) which seems to be benefitting from the ongoing premium for owning JGB’s and swapping back to USD.

In the EMG bloc, RUB (+0.8%) is the leader today, followed by ZAR (+0.7%) and MXN (+0.65%). All of these are benefitting from firmer commodity prices which, naturally are helped by the dollar’s broad weakness. But other than TRY (-0.2%) which has fallen in nine of the past ten sessions as President Erdogan and the central bank undermine the lira, and IDR (-0.3%), which has also seen a string of suffering, but this based on difficulty dealing with Covid effectively, the rest of the bloc is modestly firmer vs. the greenback.

On the data front, this morning brings Housing Starts (exp 1245K) and Building Permits (1326K), which if wildly different than expectations could have a market impact, although are likely to be ignored by traders. Rather, the trend in the dollar remains lower, with the euro actually setting new highs for the move this morning, and until we see a change in the rate structure, either by US real rates rising, or other real rates falling more aggressively, I expect this trend will continue. Hedgers, choose your spots, but don’t miss out.

Good luck and stay safe
Adf

Hardly a Sign

The thing that I don’t understand
Is why people think it’s not planned
The dollar’s decline
Is hardly a sign
The FOMC’s lost command

Based on the breathless commentary over the weekend and this morning, one would have thought that the dollar is in freefall.  It’s not!  Yes, the dollar has been sliding for the past two months, but that is a blink of an eye compared to the fact that it has been trending higher since its nadir a bit more than twelve years ago.  In fact, if one uses the euro as a proxy, which many people do, at its current level, 1.1725 as I type, the single currency remains below the average rate over its entire life since January 1999.  The point is, the current situation is hardly unprecedented nor even significant historically, it is simply a time when the dollar is weakening.

It is, however, instructive to consider what is happening that has the punditry in such a tizzy.  Arguably, the key reason the dollar has been declining lately is because real US interest rates have been falling more rapidly than real rates elsewhere.  After all, the Eurozone has had negative nominal rates since 2014.  10-year German bunds went negative in May 2019 and have remained there ever since.  Given that inflation has been positive, albeit weak, there real rates have been negative for years so the world is quite familiar with negative rates in Europe.  The US story, however, is quite different.  While nominal rates have not yet crossed the rubicon, real rates have moved from positive to negative quite recently and done so rapidly.  So, what we are really witnessing is the FX market responding to this relative change in rates, at least for the most part.  Undoubtedly, there are dollar sellers who are bearish because of their concerns over the macro growth story in the US, the second wave of Covid infections in the South and West and because of the growth in US debt issuance.  But history has shown that the most enduring impacts on a currency’s value are driven by relative interest rates and their movement.  And that is what we are seeing, US rates are falling relative to others and so the dollar is falling alongside them.

In other words, the current price action is quite normal in the broad scheme of things, and not worthy of the delirium it seems to be inspiring.  As I mentioned Friday, this is also what is driving the precious metals complex, which has seen further strength this morning (XAU +$40 or 2.1%, XAG +$1.50 or 6.7%).  And it must be noted that gold is now at a new, all-time nominal high of $1943/oz.  But since we are focusing on the concept of real valuation, while the price is higher than we saw in 2011 on a nominal basis, when adjusted for inflation it still lags pretty substantially, by about 18%, and both current and 2011 levels are significantly below gold’s inflation adjusted price seen in 1980 right after the second oil crisis.

However, the fact that the current reporting of the situation appears somewhat overhyped does not mean that the dollar cannot fall further.  And in fact, I expect that to be the case for as long as the Fed continues to add liquidity, in any form, to the economy.  Markets move at the margin, and the current marginal change is the decline in US real interest rates, hence the dollar is likely to continue to fall if US rates do as well.

The current dollar weakness begs the question about overall risk attitude.  So, a quick look around equity markets globally today shows a mixed picture at best, certainly not a strong view in either direction.  For instance, last night saw the Nikkei edge lower by 0.2% (after having been closed since Wednesday) and the Hang Seng (-0.4%) also slide.  But Shanghai (+0.25%) managed to eke out small gains.  In Europe, the DAX (+0.3%) is pushing ahead after the IFO figures bounced back much further than expected, although the CAC and FTSE 100 (-0.2% each) have both suffered slightly.  A special mention needs to be made for Spain’s IBEX (-1.3%) as the sharp increase in Covid infections seen in Catalonia has resulted in several European nations, notably the UK and Sweden, reimposing a 14-day quarantine period on people returning from Spain on holiday.  Naturally, the result is holidays that had been booked are being quickly canceled.  As to US futures, they are currently in the green, with the NASDAQ up 1.0%, although the others are far less enthusiastic.

Bond markets continue to show declining yields, with Treasuries down another basis point plus and now yielding 0.57%.  Bunds, too, are seeing demand, with yields there down 3 bps, although both Spanish and Italian debt are being sold off with yields edging higher.  In other words, the bond market is not pointing to a risk-on session.

Finally, the dollar is weak across the board, against both G10 and EMG currencies.  In the latter bloc, ZAR is the leader, up 1.3% on the back of the huge rally in precious metals, but we are also seeing the CE4 currencies all keeping pace with the euro, which is higher by 0.6% this morning.  As a group, those four currencies are higher by about 0.65%.  Asian currencies also performed well, but not quite to the standards of the European set, but it is hard to find a currency that declined overnight.  In G10 space, the SEK is the leader, rising 1.0%, cementing its role as the highest beta G10 currency.  But we cannot forget about the yen, which has rallied 0.75% so far this morning, and is now back to its lowest level since the Covid spike, and before that, prices not seen since last August.  A longer-term look at the yen shows that 105 has generally been very strong support with only the extraordinary events of this past March driving it below that level for the first time in four years.  Keep on the lookout for a move toward those Covid inspired lows of 102, although much further seems hard to believe at this point.

On the data front, this week’s highlight is undoubtedly the FOMC meeting on Wednesday, but there is plenty to see.

Today Durable Goods 7.0%
  -ex Transport 3.6%
Tuesday Case Shiller Home Prices 4.10%
  Consumer Confidence 94.4
Wednesday FOMC Rate Decision 0.0% – 0.25%
Thursday GDP Q2 -35.0%
  Personal Consumption -34.5%
  Initial Claims 1.445M
  Continuing Claims 16.3M
Friday Personal Income -0.5%
  Personal Spending 5.4%
  Core PCE 0.2% (1.0% Y/Y)
  Chicago PMI 43.9
  Michigan Sentiment 72.8

Source: Bloomberg

Of course, the GDP data on Thursday will be eye opening, as a print anywhere near forecasts will be the largest quarterly decline in history.  However, that is backward looking.  Of more importance, after the Fed of course, will be the Initial Claims data, which last week stopped trending lower.  Another tick higher there and the V-shaped recovery narrative is likely to be mortally wounded.  As to the Fed, while we will discuss it at length later this week, it seems unlikely they will do or say anything that is going to change the current market sentiment.  And that sentiment continues to be to sell dollars.

Good luck and stay safe

Adf