Current Narrative is Shifting: All Eyes Focused on the Direction of the USD

Tom Cleveland

The Almighty Dollar, whether you want it to be or not, is front-page news again. By the look of recent articles populating the financial press, one would think that every analyst known to man has suddenly developed in depth with regards to the perturbations of the U.S. Dollar and where it might be headed in the near term. The ongoing storyline is that the USD is in command. In fact, this byline sums up the latest fanaticism: “The Dollar Is Central To The Next Crisis.” Lines such as this tend to get one’s attention, especially when the current game is to pinpoint the exact time and place of the next crash.

Analysts are so confident of this conclusion that they are moved to write such blatant forecasts as the words that follow: “It is now possible to pencil in how the next credit crisis is likely to develop. At its centre is an overvalued dollar over-owned by foreigners, puffed up on speculative flows driven by interest rate differentials. These must be urgently corrected by the European Central Bank and the Bank of Japan if the distortion is to be prevented from becoming much worse.” It almost sounds like the latest screenplay for Mario Draghi to come save us all, but we doubt it. Analysts have also taken to annotating every bump the greenback takes on a daily basis:

Recent USD moves

Bloomberg prepared this particular index for the USD, according to the futures industry. Ignore for the moment the axis notations on the right, and understand that since the end of July the USD Index has fluctuated between 93.9 and 97.9, until last Friday when it dipped to the 93.4 level. The “Just Kidding” area ignited the panic in the Emerging Market (EM) arena, although capital flight has and had been prevalent since last April. The crisis in Turkey and Argentina only brought a tighter focus on the problem at hand.

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In any event, you would have thought the global economy was coming unglued as August concluded, and the greenback peaked subsequently at 95.7, but all was not lost. Thankfully, King Dollar took a breather, as did emerging market central bankers, all chorusing the same sentiment as above – “That’s more like it!” The attention garnered by the Dollar, however, suddenly brought many other related issues to the forefront, many that had been lurking below the surface and each approaching an individual tipping point as our record-breaking Bull market continued to roll on.

As troublesome as the EM financial crisis was quickly becoming, analysts began remembering that Trump’s Tax Plan, so late in the economic cycle, could not be viewed as a good thing. Yes, it may have propped up the stock market for a few short months to come, but stock results are not the economy and inflating the deficit is a ruinous decision when the outlook for interest rates is up, up and beyond. Higher interest rates, together with a stronger U.S. Dollar is a recipe for disaster. The angst over what had to give has let go a flurry of articles about dire consequences, whichever direction King Dollar might choose to go. Is there no way out? Is the party over when things look so bright?

What details of the present situation are top of mind?

The Fed meets this week with tightening proposals at the ready and a rate hike that is a 100% cinch. Technicals favor a stronger Dollar. Almost everyone and their grandmother have a Long-Dollar position, but, if a savior is to appear, it must be a weaker USD. Here is one take on the current situation: “The Fed’s unwavering commitment to gradual rate hikes and the dollar’s concurrent ascent from April through mid-August was arguably the proximate cause for the rout in emerging markets. The widening policy and economic divergence between the U.S. and the rest of the world underpinned the greenback while U.S. trade policy dented the outlook for global growth. Meanwhile, U.S. fiscal policy (i.e., the tax cuts and late-cycle fiscal stimulus) catalyzed a buyback binge and bolstered corporate bottom lines, effectively shielding U.S. stocks from the international malaise.”

Many forms of the following chart have appeared, all pictures of “un-sustainability”:

SnP vs EM


U.S. equities have been buffeted by good economic data, late cycle stimulus programs from the Trump administration, and by a corporate stock buyback agenda to beat the band, but the current acts of prestidigitation have nearly run their course. The simple law of reverting to the mean will kick in at some point to close the divergence gap, so perfectly depicted above. Many analysts are guessing that it will not take twelve months, while others point to two years as the eventual event horizon. The severity of the “Snap Back” is the only thing in question.

It is difficult to predict when the corporate stock buyback torrent will subside. Goldman is on record predicting record activity in the $1 trillion range for 2018, fueled primarily by the repatriation of foreign-based profits. Trump’s minions put new rules in place, but the intent was that these funds would be invested in capital expenditures, which would ignite a hiring boom for years to come. CAPEX investments are up, but only slightly. Buyback estimates are one thing, and actual executions, another, but as can be seen in the chart below, the two bars on the chart per year have been fairly consistent:

Buyback activity

The next topic has been with us for some time – the divergence of global central banking monetary policies. The Fed is way out in front of other major banks in its agenda for normalization for both interest rate and balance sheet indicia. The Fed meets this week, and as one analyst contends, there are four things that could transpire:

  • The Fed will surely raise its benchmark interest range by 25 basis points, and President Trump will express his irritation, since he believes that the Fed’s actions are undermining his plan to juice the economy;
  • Do not expect the Fed to be too concerned over trade tariff wars, since their impact on inflation may only be slight, if and when they occur;
  • We doubt if the Fed will be too bothered by the crisis in Emerging Market countries, since this Fed is more focused on domestic activities than on international impacts;
  • Although domestically focused, the Fed may accommodate cross-border concerns by slowing the pace of anticipated interest rate changes in 2019. Instead of four changes as in 2018, they might pull back to a conservative pace of two changes for 2019, an acknowledgement that the U.S. economy will be facing headwinds, although GDP growth will still see a healthy 2.3% growth over the calendar year, compared to 2.9% for this year.

With these four actions and a slowdown in the global economy, how can the so-called narrative shift to a weakening U.S. Dollar, the desired recipe to defuse the divergence powder keg? In other words, under these circumstances, how could the greenback weaken at all? Although analysts have been digging through the rubble in search of what could weaken the USD, they are found grasping at the following straws:

  • Since everyone is flocking to the “Long-Dollar” trade, especially before the Fed’s next announcement, contrarians posit that a short squeeze is inevitable. Even a hint from an opposing view will create an avalanche of selling;
  • Per one analyst: “The pace of offshore cash repatriation is slowing markedly and should continue to decelerate going forward. Thus, to the extent you’re counting on repatriated cash to turbo-charge the already robust buyback bid, you might want to curb your enthusiasm.”
  • China spread the news that it will defend the Yuan and add stimulus on the domestic front. Commodities and related currencies rejoiced, leading again to a weaker USD;
  • Fed watchers claim that more dovish comments are being expressed by members of this austere group, as they hit the speech-making trail;
  • The Euro actually strengthened after its recent meeting, a first after seven straight declines after previous meetings. Mario Draghi hinted that inflation was on track, even though other ECB members disagreed, but everyone loves an ebullient central bank chairman, even if unfounded;
  • The “Risk-On” trade seems to be in vogue again. EM, Shanghai, and European stocks have had an exceptional week, but still lag the S&P 500;
  • The general argument is that the U.S. has gone way beyond its ability to absorb “Risk-Off” capital. Like a full sponge, something had to give and will continue until a new equilibrium is found.

The opposing camp insists that there is no “solution” for today’s ills.

Is everyone changing direction in favor of what has been termed the “convergence trade”? A major portion of the analyst community has not been swayed by current events. For them, a weakening Dollar is a temporary breather before a more serious narrative plays out – Interest rates are rising, and massive debt service defaults will erupt, as central banks attempt to normalize further.

This group points to the unusually high levels of debt in every sector you choose. The U.S. deficit is over $21 trillion. Global debt is up to $247 trillion, having risen $177 trillion in the past ten years to more than two times the size of the global economy. Murray Gunn, head of global research at Elliott Wave International, recently said that, “We think the major economies are on the cusp of this turning into the worst recession we have seen in 10 years. Should the US economy start to shrink, and our analysis suggests that it will, the high nominal levels of debt will instantly become a very big issue.”

Monetary policies poured liquidity and cheap money into the global system, funding all sorts of enterprises, whether economically justified for the long run or not. When and where the inevitable “credit crunch” will occur is in doubt, but as one analyst quipped: “All we know is that rising interest rates will undermine business models, government finances, and consumer spending somewhere first, and it will rapidly spread from there.”

Concluding Remarks

Divergence or convergence, which narrative is it to be and will either direction lead to better times ahead? One group wants to dance the night away, while the other group sits in their chairs, waiting for the music to stop. Yes, economic data looks good, but at what price have we bought current optimism? Have we borrowed ourselves up to the brink?

These times, they are a different tune for sure, but risk and debt have never been the greatest of dance partners. Stay cautious, and be prepared!

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Tom Cleveland
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