Currencies to own as recession takes hold

This post first appeared on Patreon on 9 Jul 2018

Last week, I wrote up a macro bond play that involves three parts: currencies, spread differentials and default risk. I want to hone in on one of those three today: currencies. And here’s the lead:

China’s economy and currency are hurting

This is the macro accounting that a lot of people looking at the budding trade war don’t appreciate. The trade war between the US and China is leading to a weaker Chinese economy and a weaker Chinese currency. This is particularly true given the fact that the US is raising interest rates and the PBoC is easing monetary policy to boost its economy.

Last year, India had already overtaken China as the fastest growing major economy. The trade war will deepen that malaise. And the result will be lower growth, looser Chinese monetary policy, and a weaker currency.

Also note this from Grep Ip at the Wall Street Journal:

If a tariff generated significant new demand for the protected American sector, the resulting boost to prices and jobs would put upward pressure on inflation, interest rates and the dollar, further hurting exports.

This will act as a ‘stabiliser’ that prevents the trade flows from fully adjusting as the Trump Administration wants them to adjust.

Eventually there will be a recession

I am not in the alarmist camp that says the trade war will cause a recession. And that’s simply because trade flows are not as important in the US economy as they are in the economies of some of America’s trade partners. Nevertheless, the scenario building shows the Fed potentially overtightening. And at the same time, trade will act as a dampener on economic activity. So when the credit cycle does turn down, trade could act as an extra downside factor, helping push the economy into recession.

As the credit cycle turns down, we are going to see the flattening yield curve invert. And that was the genesis of my bullish relative value call on long-dated Treasuries last week. But that recession will likely be global in nature, one reason to think of Italy as a risk. This summer, the ECB will have almost $600 billion in Italian bonds on its balance sheet as QE starts to wind down. That gives you a sense of the importance of QE in reducing default risk for Italy. When recession risk begins to rise, the ECB will be winding this down, perfect timing to increase default risk for investors in Italian debt.

The currency play (plus a bid for Treasuries)

Clearly, this is bullish for the US dollar. But over the short-term currency markets don’t always play nice. Nevertheless, as the recession dynamics take hold the US Dollar will get bid due to its safe haven status. First, there is the liquidity factor. The US is the world’s leading reserve currency for a reason. And liquidity will cause the dollar to rise (ratcheting up pressure on the US economy via the external channel).

But a lot of this liquidity will make its way into the Treasury market due to that market’s liquidity. That will certainly remove any doubt about the ability of the US government to ‘fund’ itself as the panic unfolds. And we will see Treasury yields plummet during the initial phase of a recession, as a result.

Other safe havens will also get a bid for different reasons — due to their external positions. Think Japan, Switzerland and Singapore – all of which have major external surpluses (unlike the US external deficit).

From a relative value perspective, emerging market currencies will be the least attractive here. The Wall Street Journal is reporting that EM central banks are already going through their reserve hordes to prevent a currency freefall as the Fed cranks up short-term rates.

Watch default rates for the play

When recession begins, expect massive currency intervention. And that will set up a play that is bullish for the US dollar because of liquidity, bullish for the Japanese yen, Swiss franc and Singapore dollar because of external balances, and bearish for EM currencies all around.

Target mid-2019 as the time period to watch for these dynamics, with credit stress in EM, US corporate real estate, and high yield as credit cycle canaries in the coalmine. Actual default rates will have to rise for the credit cycle to turn. Until then, the bull market can continue.

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More