The dollar bull market will eventually break something
With the Fed having raised interest rates for the second time in ten years, in an environment in which US growth looks pretty good, we should expect more hikes to come. The question is whether the economy can withstand the hikes and what they would mean for markets. I have five asset classes to watch: Treasuries, the US Dollar, Emerging Markets, the Japanese Yen, and Gold.
Let’s start in the US. As I wrote in the last post, I have been optimistic about the US economy since August. Four months later, the Fed has rewarded the US economy with a rate hike. If the economy continues to show the same or a greater level of resilience, the Fed will keep dishing out the rewards. They predict three rewards this year. But in fact, as Tim Duy wrote a couple of days ago, the Fed could be more rewarding than anticipated:
Altogether, whereas in late 2015 the economy passed through an inflection point that derailed expectations for 100bp of rate hike, the economy looks to be hitting in the opposite infection point as 2016 draws to a close. That suggests that the central tendency of the Fed’s rate projections will prove to be too low this year.
In other words maybe, just maybe, this is the year the economy starts to feel “normal.” Rather than the Fed moving closer to the markets, the markets will move to the Fed.
But will rates going up mean a steepening or a flattening yield curve? If the long end of the curve goes up more than the Fed can raise rates, it would signal optimism about the economy going forward. It would also give the Fed a chance to pass on some interest rate relief into the next downturn both to borrowers and to banks. But how steep can the yield curve really get without it hurting equities? That is going to be the million-dollar question in the Goldilocks scenario of decent US growth and a steepening yield curve. Needless to say, a flattening yield curve would be a sign that the cuts are going to be unwound down the line when recession takes hold – sooner rather than later. The two-year is the highest in seven years. And according to Bloomberg’s Lisa Abramowicz, the 10-30 year section of the yield curve is the flattest it has been in 20 months. That’s why stocks sold off after the Fed announcement.
The fact that everyone is on the same side of the trade for long-dated Treasuries suggests — to me, at least — that there is a unusual likelihood that we see either flattening in the belly of the curve or at least flattening that induces a pause by the Fed. Trend growth above 2% keeps the Fed hiking. Anything below 1.5% will mean a pause. The grey area is in the middle. Right now we are at year-over-year trend growth of about 1.5%, up from a 3-year low of 1.27% in Q2.
Now, if the Fed is hiking, then the dollar will continue to rise. That’s because nowhere on the horizon do I see other CBs on a tightening path. Yes, the ECB decided to taper QE down to 60 Billion euros a month. But it extended its program. And to the degree banking problems in Italy are not resolved anytime soon, it may feel compelled to continue on the QE train as a backstop for Italy. The Bank of England still has Article 50 staring it in the face. The Swiss National Bank has Swiss-Euro parity breathing down its neck. And the BoJ is targeting the 10-year at 0%. None of the other major central banks are tightening like the Fed.
This is beginning to look like a secular dollar bull market then. And a secular dollar bull is going to create asset class volatility. The 1978-85 Dollar bull set off the LDC debt crisis and was only brought to heel by a coordinated intervention after the Plaza Accord. The second dollar bull that began in 1992 lasted until 2001 and fueled an epic asset bubble that again claimed the emerging markets as victims as well as developed economy investors in the TMT asset bubble. What happens this time then?
I would date this dollar bull back to the beginning of 2014 when we had the first emerging market crisis.
So we’re almost three years into this thing – and we’ve already had at least two EM scares — mini-crises, as I call them — as a result. If this dollar bull market is secular, it will be very bad for EM. The question is when do we have a real crisis. And when that crisis hits, I am not necessarily concerned about EM sovereign debt this go round. It is the EM corporate borrowers who should make us worried – because that’s where the US dollar borrowing has occurred.
I mentioned the Bank of Japan’s policy stance above when talking about policy divergence. I think this bears noting because the Japanese are targeting price instead of quantity now. As the monopoly supplier of base assets in their currency area, the Bank of Japan has ironclad control over not just short rates but any rate it targets in its currency area. It has infinite firepower through its ability to buy into assets with money it creates out of thin air. And that means its 0% rate target for 10-year JGBs is credible. Only a change in policy tactics, inflation or economic growth changes the credibility of that commitment. So what does this mean in a world in which Fed policy is dragging up bond yields in tow globally? It means a falling yen and that could be bullish for the Japanese economy.
Finally, there’s gold. The traditional thinking on gold is that it’s an inflation hedge. But what if you think of gold as just a currency? In a secular dollar bull market, gold is a currency measured against a rising asset – the US dollar. And that makes it difficult for gold to rally. So a secular bull market in the dollar is not bullish for gold — even if we see inflation in the US.
So all of this comes back to the ability of the US economy to stay afloat in a world of rising interest rates. Right now, I think it can do and I am optimistic about the near-term. That makes me bullish on the dollar but bearish on the Yen, EM and gold. I am neutral to bullish on Treasuries even so because of the out-sized short position overhanging the market and the long-term headwinds associated with private debt and difficult demographics. These are the five markets I would be watching in a post-Fed hike world.