Friday, December 16, 2016

The 2017 Dollar Crisis?

Chelsey Dulaney of the Wall Street Journal reports, Dollar Surges as U.S. Prepares for Higher Rates:
A dollar surge that began after the U.S. election has accelerated with this week’s Federal Reserve interest-rate increase, pointing to a possible reckoning in coming months for economies around the globe.

The WSJ Dollar Index of the dollar’s value against 16 major trading partners hit a 14-year high Thursday, reflecting expectations that the Fed will pick up the pace of rate increases next year as the U.S. economy gains momentum.

A sharp increase in the dollar stands to have long-lived economic consequences, potentially hampering a U.S. earnings recovery and making the trillions in dollar-denominated debt around the world more expensive to pay back.

But the dollar’s renaissance this year already is rippling through global financial markets, sending currencies from Japan and India to Turkey and Brazil tumbling and presenting companies, consumers and governments in those nations with a list of increasingly difficult choices.

In China, fears that a rising dollar will destabilize trading in the yuan has swept financial markets, sending the Chinese currency to its lowest against the dollar in over eight years and raising concerns that outflows could increase. Such an outcome could signal further economic weakness ahead at a time when Chinese growth is slowing and could ripple through currency markets to push other emerging foreign-exchange rates down.

“China is going to become a big concern,” said Paresh Upadhyaya, a portfolio manager at Pioneer Investments. “They’re already trying to manage capital outflows, and this is going to put more pressure on the country.”

Japan’s yen fell to 118.18 against the dollar, its seventh decline in 10 days. That represents about an 11% retreat since Donald Trump was elected president Nov. 8.

The weaker yen will make Japan’s exports more competitive and could boost growth, and Tokyo’s Nikkei 225 stock index has risen for eight consecutive days. But a falling currency will test policy makers at the Bank of Japan who in recent months have sought to anchor the yield of the 10-year Japanese government bond at zero.

Now, though, prices on those bonds have been under pressure amid a global selloff on hopes of an improved economic outlook.

Japan’s central bank is considering raising its assessment of the nation’s economy for the first time since May 2015 as the weaker yen boosts its exports, The Wall Street Journal reported this week.

The euro also edged closer to parity against the dollar, at $1.0415, its lowest level against the dollar since 2003.

A few central banks have already acted to support their faltering currencies. Mexico on Thursday raised interest rates by a half-percentage point—twice what many analysts had expected—as it seeks to curb inflation driven by a weaker peso. Central banks in Indonesia and Malaysia have also moved to prop up their currencies since the U.S. election.

Some analysts said that the Chinese yuan’s decline could revive some fears about competitive devaluations among developing nations, especially if Mr. Trump’s protectionist trade proposals spark a trade war.

In the U.S., bond prices tumbled on Thursday, sending the yield on the 10-year U.S. Treasury note to 2.58%, its highest since September 2014. Prices drop when yields rise. The decline reflected in part a reaction to the Federal Reserve’s indication Wednesday that it expected interest rates to rise faster than previously projected.

The Dow Jones Industrial Average rose 59.71 points, or 0.3%, to 19852.24, coming within 50 points of its first intraday trade above 20000 before cooling off in afternoon trading. Financial shares led Thursday’s gains, extending a sharp rally that began in the hours after Mr. Trump’s election. Since then, the S&P Financials index of banks, insurers and others is up 18%.

A stronger dollar isn’t all bad. It increases the purchasing power of U.S. consumers by making foreign travel and imported products cheaper. And U.S. stock markets have been taking the dollar’s strength in stride with recent all-time highs, despite the threat that the strong dollar will curb a nascent recovery in corporate profits.

In Europe, where growth has also been sluggish, the weaker euro could help support exports and inflation. Morgan Stanley thinks the euro will fall to parity with the dollar around the middle of 2017.

But most vulnerable to the effect are emerging markets. More than $17 billion in foreign investment has departed emerging-market stocks and bonds since the U.S. election, according to the Institute of International Finance.

Investors worry that Mr. Trump’s proposed protectionist trade policies could hurt exports from developing economies. Emerging-market debt also looks less attractive when U.S. and other developed-market bond yields are rising.

Debt in these countries has risen in recent years, as many governments and companies took advantage of the global hunt for yield and issued more debt both at home and abroad. Developing countries have more than $200 billion in dollar-denominated bonds and loans due next year, IIF data show.
Last Friday, I discussed my macro views and stock market views in a lengthy comment going over the unleashing of animal spirits. In that comment, I started off by going over my macro views:
I view the world as a constant struggle between inflation and deflation. If policymakers fail to deliver the right amount of monetary and fiscal stimulus, then deflation will eventually take over and that will clobber risk assets (stocks, corporate bonds, commodities and commodity currencies) but benefit good old US nominal long bonds (TLT), the ultimate diversifier in a deflationary environment.

Where has deflation been most prevalent in the world? Japan, Euroland and China. Notice the article above states that the US dollar index (DXY) is rising and now stands at a five-year high relative to a basket of currencies (click on image):



As you can see, the US dollar has been on a tear since early August when I told my readers to ignore Morgan Stanley's call that the greenback is set to tumble (my best call of the year and their worst one ever). It is basically hitting a multi-year high.

So what does the US dollar rally mean and why should you care? Well, the US dollar has rallied mostly versus the euro (close to parity which is another call I made back in March) and the yen.

The decline in the yen and euro is actually good for Euroland and Japan because it means European and Japanese exporters will benefit from the devaluation in their respective currency. This is why Japanese and European stock markets have rallied sharply. It's also good news for fighting deflation in these regions because a decline in their currency increases import prices there, raising inflation expectations in these regions.

Unfortunately, raising inflation expectations via a declining currency is not the good type of inflation. It's a temporary reprieve to a long-term structural problem. The good type of inflation comes from rising wages when the labor force is expanding because that increases aggregate demand and shows a strong, vibrant economy.

Now, what does the rising US dollar mean for the United States? It's the opposite effect, meaning it will hurt US exporters and lower inflation expectations in the US. In effect, the US is taking on the rest of the world's deflation demons trying to stave off a global deflationary calamity.

Will it work? That is the multi-trillion dollar question which is why I began talking about global deflation and currencies because as Bridgewater's Bob Prince noted in his presentation in Montreal, with interest rates at historic lows and central banks pushing on a string, currency volatility will pick up. I would add this is where the epic battle versus global deflation will take place.

But again, currency devaluation is only a temporary reprieve to a long-term structural problem fueling global deflation. The six structural factors that I keep referring to are:
  1. High structural unemployment in the developed world (too many people are chronically unemployed and we risk seeing a lost generation if trend continues)
  2. Rising and unsustainable inequality (negatively impacts aggregate demand)
  3. Aging demographics, especially in Europe and Japan (older people get, the less they spend, especially if they succumb to pension poverty)
  4. The global pension crisis (shift from DB to DC pensions leads to more pension poverty and exacerbates rising inequality which is deflationary)
  5. High and unsustainable debt (governments with high debt are constrained by how much they can borrow and spend)
  6. Massive technological disruptions (Amazon, Priceline, and robots taking over everything!)
These six structural factors are why I'm convinced that global deflation is gaining steam and why we have yet to see the secular lows in global and US bond yields.

But now we have a newly elected US president who has promised a lot of things, including spending one trillion in infrastructure and cutting personal and corporate tax rates.

What will this fiscal thrust do? Hopefully it will help create more jobs and fight some of the chronic problems plaguing the US labor market. But if you really think about it, this too is a temporary boost to economic activity because once it's all said and done, those infrastructure jobs will disappear and US debt will explode up, which effectively means higher debt servicing costs (especially if interest rates keep rising), and less money to stimulate the economy via fiscal policy down the road.

This is why some people think Donald Trump's new Treasury secretary, Steven Mnuchin, is just kicking the can down the road if he goes ahead and issues Treasurys with longer maturities in an effort to cushion the US economy from rising interest rates.

The above is a condensed version of the major macro themes that are on my mind, but there is another one that bothers me a lot, what does a rising US dollar and Trump's presidency mean for emerging markets (EEM)? As the US dollar rises, it will hurt commodity exporting emerging markets and raise dollar-denominated debt but some think if handled correctly, emerging markets can thrive under President Trump.

That all remains to be seen and my biggest fear is that if a Trump administration follows through with protectionist policies which will antagonize others to retaliate with their own trade tariffs, it will cost American jobs and wreak havoc in emerging markets. And another crisis in Asia will basically cement global deflation for a very long time.

This is the global macro backdrop every investor needs to bear in mind. So far markets don't seem to care. Trump's victory has unleashed animal spirits in the stock market and boosted consumer confidence to a 12-year high.

It's all good, reflation is back, deflation is dead, Trump will make sure of it. Unfortunately, it's not that easy and as I keep warning you, President Trump could feel the wrath of the bond market (just like Bill Clinton and others have done in the past) and if his administration isn't careful, it will make a series of policy errors that will spell the decline of the American economy for a very long time.
At this writing, the US dollar index (DXY) is hovering around 103 and is showing no signs of losing steam any time soon.

There are a lot of moving parts to the global economy but the key things to remember are the following:
  • The surging US dollar continues to gain steam after the US elections, especially relative to the yen and euro. 
  • The weakening yen and euro will temporarily boost exports which is one reason why their stock markets are going well. 
  • The weakening yen and euro will also temporarily raise inflation expectations in these regions as import prices rise, leading to a temporary rise in inflation expectations. This is one factor driving the yields of their sovereign bonds higher and bond prices there lower.
  • In effect, the surging greenback (US dollar) is relieving deflationary tension in these developed markets, allowing them to try to escape a long bout of deflation. The problem is that this is a temporary (cyclical) reprieve based on currency fluctuations, not a long-term structural one based on economic fundamentals which would raise wages and bolster aggregate demand for a long time.
  • The surging greenback however means the US is importing deflation from the rest of the world and this will lower US inflation expectations going forward via lower import prices, which is bullish for US bonds.
  • But the surging US dollar is causing all sorts of problems in China which has its currency pegged to the US dollar and a basket of other currencies. If things get really bad, competitive devaluation in Asia will cause another financial crisis there and create another deflationary tsunami which will spread around the world (this too is bullish for US bonds).
Now, let me go over an article that appeared this week, US import prices dip in November, but trend is away from deflation:
Import prices in the States slipped in November but the underlying trend was for a move away from deflation on the back of rising commodity prices and a waning dampening effect from strength in the US dollar, economists said.

The US import price index dipped by 0.3% month-on-month and 0.1% year-on-year, according to the Bureau of Labor Statistics.

Fuel import prices dropped at a 3.9% pace over the month and advanced by 2.7% on the year, while non-fuel import prices slipped 0.1% on the month and were down by 0.3% in comparison to the year ago month.

On the export side of the equation, prices of exports were off by 0.1% on the month and 0.3% over the past year.

Commenting on the data, Blerina Uruci at Barclays Research said: "Compared with a year ago, nonpetroleum import prices fell 0.2% y/y, a significant improvement from the strong deflationary trend in 2014 and 2015. The recent upward trend suggests that the impulse from the dollar appreciation has faded.

"We maintain our view that import prices will gradually move away from deflation territory in the coming months, following improving global commodity prices and the gradual waning of the effect of a stronger dollar."
Unlike Blerina Uruci at Barclays Research, I don't see the US dollar appreciation as such a benign trend. True, there is no immediate worry of US deflation but longer term, if this trend continues and wreaks havoc in Asian and other economies, it will potentially mean deflation coming to America.

"Give it up Leo, deflation is dead, President-elect Trump will cut personal and corporate taxes, get rid of regulations, spend a trillion dollars on infrastructure, and the US will be booming, growing at 4-5% in no time, leading the world out of this deflationary slump."

I wish it were that easy folks. Unfortunately the "Trump reflation rally" is all smoke and mirrors and a lot of things can go wrong in the next year, chief among them is what I call the US dollar crisis where the strength in the greenback continues and wreaks havoc on emerging Asia.

It's also worth noting Europe is still a mess and the Greek debt crisis is still lurking but is now superseded by an Italian banking crisis. This is why I've been telling my readers to keep shorting the euro and not to be surprised if it hits parity or even goes below parity if another crisis develops there.

A couple of last points you should be made aware of. The big trends in stocks, bonds and currencies typically go on longer than people think because there are multi-billion dollar CTA funds all playing trends as well as large trading outfits that play carry trades. For example, as the yen weakens, hedge funds and large trading outfits are loading up on the yen carry trade to invest in risk assets around the world, including US stocks and corporate bonds.

Something else really irks me. When you read doom and gloom nonsense on Zero Hedge about China and foreign central banks dumping a record $403 billion of US Treasuries, please ignore it. They obviously do not understand basic economic truisms, like one country's current account deficit (US) is another country's capital account surplus (China, Japan and petro countries looking to recycle their US dollar profits back into the US financial system).

Lastly, the Fed raised rates this week and everyone is harping on the inflation reference in the FOMC statement:
Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since mid-year. Job gains have been solid in recent months and the unemployment rate has declined. Household spending has been rising moderately but business fixed investment has remained soft. Inflation has increased since earlier this year but is still below the Committee's 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation have moved up considerably but still are low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months. 
After reading my comment on how a surging greenback will lower import prices and potentially wreak havoc in emerging markets, what are the odds that a year from now the Fed will still be worried about rising US inflation expectations? I put them at low to zilch and if a crisis develops, the Fed will be more petrified than ever of a global deflationary tsunami that I warned of at the beginning of the year.

As always, please remember to share these comments with as many people as possible and also take the time to read my comment on the unleashing of animal spirits so you can understand my stock and bond market calls in more detail.

Also, please take the time to subscribe or donate to this blog via PayPal at the top right-hand side and support my efforts in bringing you great insights on pensions and investments. The PayPal options are on the right-hand side under my picture (view web version on your cell phones). I thank all the retail and institutional investors who support this blog first and foremost financially, it is greatly appreciated.

Below, the US dollar has surged against the loonie following the Federal Reserve’s interest rate hike. Greg Anderson, FX Strategist, BMO Capital Markets talks to Bloomberg TV Canada about why the rally isn’t over.

Second, the Fed might have projected three rate hikes next year but the stronger USD will slow down its pace of rate hikes, says Citibank Singapore's Zal Devitre. Citi thinks the Fed will hike twice as opposed to three times next year. I'm not even convinced it will hike twice next year, especially if a crisis develops in Asia or Europe.

Third, Brian McMahon, Thornburg Investment Management, and Louis Navellier & Associates share their top stock plays. I'm not particularly interested in their stock picks but agree with Navellier's comments at the end on the rally in financials, energy and metal stocks being nothing more than a big short squeeze which isn't based on real fundamentals.

Fourth, Todd Gordon, TradingAnalysis.com, and Richard Bernstein, Richard Bernstein Advisors, weigh in on what's driving stocks to lofty levels. Notice no discussion on CTAs and the yen carry trade driving all risk assets higher but Bernstein is right, global PMIs have accelerated recently, the last spike (in my opinion) before they come back down to earth next year.

Fifth, Kathy Lien, BK Asset Management, and Chris Retzler, Needham Growth Fund, discuss the market's rally and the strong US dollar.

Lastly, it is the weekend so I embedded The Hitchhiker’s Guide through a Collapsing Europe – by DiEM25ers Yanis Varoufakis & Srećko Horvat. I still think Varoufakis is an insufferable, pompous, and hopelessly arrogant academic who is incapable of admitting his mistakes (he was responsible for closing Greek banks and never understood what Greece really needs).

Still, there is no denying he's very smart and they both raise important issues in this long discussion concerning the future of Europe.






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