Thursday, June 9, 2016

Endgame For The Dollar Bull Run Is Near?

Roger Blitz of the Financial Times reports, Endgame for dollar bull run approaches:
The ailing dollar got out of bed on Monday to see what US Federal Reserve chair Janet Yellen had to say, shrugged its shoulders and promptly headed back under the duvet.

Laid low by Friday’s spectacularly poor jobs growth data, the dollar barely moved in response to Ms Yellen’s health-check on that other patient, the US economy.

Although she suggested that the economy was not as bad as the market thinks, the greenback looks set for a long bout of convalescence.

It has been a year of feverish activity for the world’s biggest reserve currency — looking sprightly in the early months amid global market turmoil, weakening from an insipid US economy and Ms Yellen’s most dovish speech in March, perking up in May as the economy warmed up, and now sick again.

There is only so much an old guy can take, even one as formidable as the dollar, and there is only so much optimism to go around for dollar bulls.

The market has killed off a rate rise at next week’s Fed meeting and does not offer a better than even probability of the Fed moving on rates until December.

“It leaves the US dollar more vulnerable to the downside in the near-term,” says Lee Hardman, currency strategist at MUFG. BNP Paribas strategists expect the euro to return to the early-May highs of $1.16.

A Fed fixated with preventing market turbulence is one whose shifts in guidance are pivotal to how the market reacts, says Neil Mellor, FX strategist at BNY Mellon — and that makes rate rises so acutely difficult.

“In the meantime, the world may have to face up to a renewed phase of dollar weakness — anathema to any central bank whose economy is subjected to unrelentingly low price pressures, which to all intents and purposes, means almost all of the G20 nations,” he says in a note.

This, though, may be more than just a phase. The endgame for the dollar bull run is approaching, and may even have arrived.

Dollar bulls will cling on, pointing to German bond yields now in negative territory, which should keep interest rate differentials between the US and Europe and Japan elevated and therefore support the dollar.

In the longer term, “the dollar upside is behind us”, says Jan Dehn, head of research at Ashmore Investment Management. For one thing, the dollar’s 40 per cent rise since its quantitative easing programme has made the currency a victim of its own success.

“It’s become so strong that it’s difficult to grow and to raise rates. If you tighten, you threaten the stability of the financial markets,” said Mr Dehn.

For another, says G10 FX strategist Athanasios Vamvakidis of Bank of America Merrill Lynch, this is a FX market that this year has been driven less by fundamentals and more by market positioning and the comments of Fed members.

“Even if Friday’s job data are an outlier, and the data are better, it’s hard to see a substantial improvement in the dollar,” Mr Vamvakidis says. In any case, he adds, all the other economic data suggests the US economy lacks momentum.

“It is very hard to see either another dollar rally or a sell-off. Positioning is neutral at this stage.”

That leaves the dollar probably going through further periodic phases of weakness and strength for the rest of 2016, but likely to remain rangebound. “We have reached a plateau,” says Mr Dehn.

That may suit many parts of the global economy. Dollar strength was a 2015 problem for, among others, the US economy and its exporters, as well as emerging markets.

But by the start of 2016, it was in the interests of most of the global economy to see the dollar weaker.

“Suddenly everybody’s interests were aligned,” Mr Dehn argues, leading to the so-called “currency wars truce” at February’s G10 meeting in Shanghai and the Fed turning decidedly cautious.

So a weaker dollar may be the best medicine for several actors, including commodity and EM currencies — but not for the currencies of Europe and Japan, which must cope with the pressure of FX appreciation on their fragile economies.

Their currencies are being driven by a mixture of risk sentiment, a squeeze in dollar positioning and the market’s downbeat view of their central banks, says Mr Vamvakidis.

“The market is pricing in increasing restraints on the European Central Bank while, in the Bank of Japan’s case, the market has realised that Abenomics might be failing,” he says.

As for the dollar, the next chapter will be written when the Fed finally presses the rate rise button. That will be influenced by the upward path of US inflation, which Mr Dehn says will pose a dilemma for the Fed — does it crush inflation or protect the markets and support economic recovery?

The timing, he predicts, will come at the end of the year or the start of 2017 — by when the US will have elected a new president. Who knows just when it will be safe for the dollar to emerge from under the duvet.
At the risk of belaboring this point, pay attention to the US dollar, its strength or weakness has big implications for markets and the global economy.

In my last comment looking at whether US stocks will melt up, I stated that I foresee the US dollar gaining strength in the second half of the year and this will weigh on oil prices (USO), energy (XLE), metals and mining (XME), and gold shares, especially gold miners (GDX) which rallied hard this year.  It will also weigh on industrials (XLI) and emerging markets (EEM).

However, I also stated there are clear signs that the US economy is slowing and it's likely the Fed is out of the way for the remainder of the year. If the US economy is slowing and the Fed doesn't raise rates this year, how can the US dollar index (DXY) gain in the second half of the year?

Good question. Let's assume the US dollar continues to weaken, especially relative to the yen but also relative to the euro. How long can this go on before we see another Asian financial crisis? Remember, US dollar weakness comes at the expense of a stronger yen and euro, impacting their exports at a time when they're still grappling with deflation.

So far, the yen has born the brunt of US dollar weakness but the yen's surge could trigger a crisis which reverberates around the world.

That's why when I read nonsense on the endgame for the dollar bull run approaching, I ask myself what exactly that means when Japan is grappling with deflation? US dollar weakness means yen strength, which can't go on forever without Japanese authorities intervening in a massive way.

Also, if the Fed stays put and the US dollar keeps weakening, other central banks are going to continue doing whatever they can to ease the pressure of a strengthening currency.

Interestingly, the euro pushed higher against the US dollar on Wednesday hitting its highest level in three weeks as the European Central Bank launched new stimulus operations, buying buy bonds issued by companies in a bid to kickstart eurozone inflation but the ECB is so far behind the deflation curve that it's unlikely to resurrect inflation there.

Also worth noting that according to the ECB, the euro's importance as a tool of the global financial system is dwindling:
The euro has struggled to keep pace as a globally used currency in the face of low interest rates and poor global growth.

At 19.9 percent, the share of the euro in foreign exchange reserves has hit its lowest level since 2000 according to the ECB's annual report on the currency's role.

"Moreover, the share of the euro in foreign exchange reserves has fallen by almost three percentage points since its peak in 2009, i.e. before the onset of the euro area sovereign debt crisis," the ECB said in the annual report released Wednesday.

"The euro remained the second-most important currency in the international monetary system, but with a significant gap to the U.S. dollar," the ECB added.

As a comparison the U.S. dollar makes up 64 percent of FX reserves, but according to IMF and ECB calculations is also falling, down by 5 percent since 2007.

Following the announcement of the ECB asset purchase program, use of the euro in foreign currency debt issuance peaked in early 2015, but has since faded as levels of dollar-denominated debt rose.

For cross-border loans, the use of the euro actually ticked up in 2015 but the report said volumes remained limited outside of the European Union.
Now, let's move back to the United States. What if the May payroll numbers were a 'statistical outlier' and the US economy bounces back in June? Well, in that case, it gives the Fed a window to raise rates at least once in July. If that happens, the US dollar will strengthen on the back of a stronger economy and rate hikes down the road, easing tensions on the yen and euro.

Of course, the Fed has to be careful here because if it raises rates too abruptly, it can wreak havoc in emerging markets where many nations will see their dollar denominated debt balloon.

On this last point, Jamie McGeever of Reuters reports, Forex anomalies threaten broader financial market calm:
Distortions in dollar-based interest rate markets resulting from the U.S. currency's two-year rally pose a growing threat to financial stability, the Bank for International Settlements warned on Wednesday.

Hyun Song Shin, head of research at the BIS, said a breakdown in what is known as covered interest parity and the resulting strains in cross-currency basis rates could have a negative impact across the global financial system.

The Swiss-based BIS acts as a forum for major central banks.

"In spite of the outward tranquility, there are tensions beneath the surface," Shin told a World Bank conference in Washington.

"The financial tail appears to be wagging the real economy dog. This is not how things are supposed to work. The key takeaway is that a stronger dollar is associated with more severe market anomalies," Shin said.

Covered interest parity theory holds that interest rates implied by foreign exchange trading should be consistent with market interest rates, so that there are no interest rate arbitrage opportunities between the two.

But the current implied dollar interest rate from currency swaps is above Libor, meaning that borrowers of dollars in the FX swap market are paying more than the rate available in the open market. The deviations are notable in euros and Swiss francs, and are particularly large in Japanese yen.

The breakdown of covered interest parity is a symptom of tighter dollar credit conditions putting the squeeze on accumulated dollar liabilities built up during years in which dollar credit was cheap and plentiful, Shin said.

During the period of dollar weakness before 2014, cross-border dollar credit grew strongly and was easily obtained. But as the dollar strengthens, banks find it more challenging to roll over that debt.

"A weaker dollar is associated with greater lending in dollars, lower volatility and more risk-taking, but a stronger dollar is associated with higher volatility and a recoiling from risk-taking," Shin said.

The difference between U.S. dollar Libor and the FX swap-implied dollar interest rate is the "cross-currency basis". The textbooks say this should be virtually zero, but again there is a notable dollar premium building up, especially versus the yen.

The three-month dollar/yen currency basis is trading around -70 basis points, signifying a 70 bps premium for dollar funding over comparable yen borrowings. It has been around -60 bps or more for most of this year, and neared -100 bps in late 2011.

The dollar has rallied 20 percent against a basket of major currencies since mid-2014, a period that has coincided with more subdued risk-taking across the banking and financial world.

This means that a rising debt burden becomes increasingly difficult to sustain. The stock of dollar-denominated debt of non-banks outside the United States currently stands at $9.7 trillion, of which $3.3 trillion is in emerging markets.

Shin's comments on Wednesday follow similar warnings a month ago from his BIS colleague Claudio Borio that the dollar's overwhelming position of dominance in the global financial system posed risks to world financial stability.
You read this and you understand why some think the world economy is held hostage to the US dollar but I take all this talk of "a stronger dollar is associated with higher volatility and a recoiling from risk-taking" with a grain of salt.

I can make the same argument for periods of a stronger yen and how that is also
associated with higher volatility and a recoiling from risk-taking. Moreover, as I've stated before, the yen's surge could trigger a crisis which will reverberate around the world.

One thing is for sure, the weakening US dollar is a boon for commodities but if the US economy is weakening, it's hard to forecast oil hitting $100 a barrel or call for a new bull market in commodities. As far as the US dollar, sure looks like a lot of the weakness is already priced in and it can rise relative to the yen and euro in the second half of the year.

Below, Stephen Guilfoyle talks about how today's weak dollar is sending everything from gold and corn to the moon. He also discusses why small cap stocks are leading the markets and how the Fed might throw a bone to other central banks next Wednesday.

For now, the weak US dollar is sending everything to the moon, but the deflation supercycle is far from dead, and at one point gravity will kick in, sending everything right back down to Earth and the US dollar right back up (classic flight to safety, everybody wants to own USD).

And then people wonder why a bearish George Soros is returning to the stress of trading at the tender age of 85. I wonder what he thinks about the endgame for the US dollar bull run approaching.

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