Coming Out of the Closet
I have decided that it is time for me to come out of the closet. My colleagues have for months counseled me that it is a choice, that it doesn’t have to be this way, but after considerable introspection, I came to the conclusion that I was simply born this way and there is very little I can do about it. It is simply the way I’m wired. So here it is. I tend to think macro. There, I’ve said it.
Performance of global macro strategies have been rather poor over the past five years, much to my consternation, primarily due to a coordinated global monetary policy regime, (think Fed, ECB [European Central Bank], BOJ [Bank of Japan], and BoE [Bank of England]) that has squeezed out the historical patterns of difference between geographies and asset classes and done one heck of a bang-up job suppressing volatility. But recently, this changed. Macro funds were among the best performing strategies in September, with a gain of 1.1% on average. Monetary policies are becoming uncoupled. Divergent national growth rates are making the Fed and the BoE more hawkish and the ECB and BOJ more dovish. Now every major economic region is starting to have to fend for itself, giving macro strategies room to work, much to the relief of macro fund managers and strategists all over the world.
Now that you know my secret, I can confess I’m worried. “Yeah, yeah, what’s new?” you say. Fair enough, but that’s my job and this time, my fears are a little different. For years I’ve been nervous, like many, about the unintended consequences of all this quantitative easing. The straightforward assessment was that if the world became flooded with dollars, the value of the dollar would decline. For those who are long-time readers of this blog, you know that is a potential outcome that has been discussed at length. But over the past quarter or so there’s been a shift in the markets that has me looking at a different potential outcome.
As a woman with macro-tendencies, one of my guilty pleasures is talking with other macro-minded folk about the global dynamics we see emerging. One of my favorite partners for this is Raoul Pal, who I believe is one of the smartest chaps around. Raoul was commenting on the impact of the appreciating dollar and its potentially deflationary effects, which got me thinking. What if… just what if the flooding of dollars is more akin to a really savvy drug dealer?
An enterprising dealer would be wise to flood the market with say cheap dopium, so much dopium that people who normally wouldn’t even be interested sample it and find that it can help give them an extra kick in their day (yield) when injected into their blood (carry-trade). But they tell themselves they’ll only use for just this month’s really busy workload (challenging yield-generating environment). Once things get back to normal, (normalized interest rates) they’ll get clean. But the workload (financial suppression) continues to be challenging. Meanwhile the flow of dopium continues unabated, (QE continues and the dollar remains relatively stable). So what really is the risk with a solid and steady supplier?
Recently the dealer (Fed) has come to the conclusion that to continue pushing so much dopium, (flooding the market with dollars by buying nearly all the new Treasury bonds and even MBS issued every month) may eventually be problematic, but rather than be mobbed by crazy addicts (investors) the dealer (Fed) decides to try and slowly reduce the flow. Now anyone who’s found themselves staring nervously into an empty coffee cup during an interminable morning meeting with no potential for a refill in sight knows the power of addiction. Demand becomes increasingly inelastic, i.e. price becomes less and less relevant because you just need it, leading to….
After a period of relative stability, the USD has strengthened considerably, with the US Dollar Spot Index up nearly 9% since its recent low in early May. I think three of the biggest areas of concern with a rising dollar are the carry trade, emerging market equity performance and the commodities complex, particularly with respect to China.
Here’s how the carry trade works:
1.Funds and/or traders for very large institutions borrow dollars at relatively lower interest rates than those in emerging markets. These dollars are then converted into the currency of the emerging market for the desired bonds.
2.This emerging market currency is then used to buy bonds that have a much higher interest rate than the US. The difference between the two interest rates is referred to as “positive carry.”
3.The more traders that do this, the more the price of bonds in the emerging market rises, generating champagne worthy profits. This can get particularly profitable the more leverage is used.
If the dollar continues to strengthen against these currencies, then traders need more of the emerging market currency to pay off the interest and principle for the dollars borrowed and the greater the leverage, the worse the problem. As the dollar strengthens, the value of the carry trade unravels to the point of generating loss and this can happen in an accelerating manner if enough carry trades around the world need to be unwound simultaneously.
The second area of concern is emerging market equities, which have fallen dramatically in recent weeks, down over 9% since their recent high on September 5th and down 7.6% in the month of September alone, the most since May 2012, led by China and Hong Kong. The Japanese yen fell 5.1% in September versus the dollar to the weakest level since August 2008.
When emerging market stocks underperform relative to US equities with a strengthening dollar, additional pressure is placed on already vulnerable economies leading to further capital outflows.
The third area for concern is the commodity complex as commodities are primarily priced in dollars, so if you want to buy oil or copper, for example, you need to first convert into dollars. The stronger the dollar, the more of the non-dollar currency you need and the less oil and copper you get for each dollar. It’s all relative.
Now that I’ve come out of the closet she can openly put on her macro hat and look around the world and what we see is a lot of reasons to be nervous that a flight to safety could occur… and that means a further strengthening dollar, which itself is the very catalyst to cause the flight.China is facing an economic slowdown that ought to have everyone paying attention, particularly since they’ve used their commodity inventory as collateral for borrowing. With commodity prices like copper falling, down 8% since its recent July 3rd high and oil down nearly 15% since its June 12th high commodity collateral is under pressure. China’s political stability depends on continued economic growth. The renminbi is currently tied to the dollar, so a stronger dollar means a stronger renminbi, which means Chinese exports are relatively more expensive for their customers.
Granted, China is trying to develop its internal consumer consumption economy, but that takes time and it desperately needs to keep its people working and that work is dependent on people outside the country buying stuff made in China! So… would it really be all that surprising to see China alter its monetary policy to pull away from the dollar? For that matter, with the strains in the relationship between Beijing and Hong Kong from all these protests, might China also take steps to impact the Hong Kong dollar, a major source of strength for the island? Even just the fear of that possibility could result in a capital flight for all that mainland China wealth sitting in Hong Kong dollars.
Don’t forget how this affects Russia! That country’s oil revenues are its primary source of foreign currency reserves, which it needs to service its international debt. As these reserves come under pressure, so does Russian debt.
Just to top it off, European economies continue to struggle while in recent months the S&P500 has outperformed the major European market indices, again potentially leading to inflows into the US, increasing demand for the dollar. The lack of traction from the ECB’s latest QE attempts is only exacerbating concerns.
We’ve seen this story before, starting in 1981 in Latin America and then again in 1998 in Asia. While we think it is unlikely that this unwinding and potentially explosive dollar move up will happen in the very near term, there are a lot of factors in place to give it decent odds in the coming months, perhaps into early next year, albeit with the usual bumps along the way.
Bottom Line:
If the dollar strengthening story plays out, we would likely see the following:
•Negative impact on U.S. earnings (exports become relatively more expensive to non-U.S. buyers),
•Emerging markets would suffer from capital flight
•Commodities and commodity related-securities, (think oil companies, copper mining etc.) would suffer
•Earnings for Japanese and European exporters would benefit as their goods become relatively less expensive
•U.S. Treasury yields would fall…deflationary pressures increase
