John Hardy
Head of FX Strategy
Summary: A strong USD is simply "too toxic" for the economy. Will the Fed implement yield-curve control?
In our Q1 outlook, we continued our argument in favour of the longer-term weakening of the US dollar, with the important caveat that at times, sharply higher US yields and a steepening yield curve in the US in anticipation of heavy incoming stimulus could support the US dollar and frustrate USD bears. From our Q1 outlook: “That brings us to the potential spoiler for an easy path lower for the US dollar despite the compelling fundamentals for the USD bearish case noted above: a steepening yield curve and a further rise in US long yields, which broke higher above key thresholds – like 1.00% for the US 10-year treasury benchmark – in the first week of 2021”.
Indeed, a sharp acceleration higher in US yields later in Q1 helped to trigger a notable USD snap-back rally, particularly as the Fed seemed unimpressed with the move, with Fed Chair Powell merely indicating that the move “caught (his) attention”. The most intense portion of the rise in yields unfolded in the wake of a disorderly 7-year US Treasury auction, where there were even signs of market dysfunction and wide bid-ask spreads. The culprit was a complex mixture of factors, including plumbing issues in the financial system as US banks were bumping up against limits for how many treasuries they were willing or able to hold. At the same time, the US Treasury was winding down its account at the Federal Reserve (where it had built up a war chest of over $1.6 trillion last year to store up for pandemic-related spending), and this was creating disruptions at the shortest end of the yield curve and in US money markets.
From here, the most rapid route to the resumption of a US dollar sell-off would be if longer US yields simply cool their heels for a while and don’t rise much above the cycle highs established in Q1, even as risk sentiment and the opening up continue to show solid economic activity and employment improvement in Q2. Yields have, after all, priced in some of the inflationary potential from the incoming stimulus and the basing effects from price crashes last year that will mean some very high inflation readings into the summer months. The US treasury also has a sufficiently large war chest to take us late into the year before it needs to vastly increase issuance, which would see yields rising from a supply/demand imbalance.
Alternatively, the stimulus roll-out could so clearly be super-heating the US economy in coming months that US longer yields quickly pick up higher and begin breaking things again, together with a stronger US dollar. We see this as a self-limiting process, however, as at some level of rising longer yields and even a rising USD, the Fed (and more importantly the Treasury) will have to push back. This is the chief question in the longer term anyway for the US dollar – how does the US treasury keep itself funded? Going into Q4 and 2022, unless US savers decide to drastically increase their already high savings rates and/or new foreign buying interest comes on board for US government paper, the issuance gap will have to be closed somehow or it will crowd out investment elsewhere and send real interest rates unacceptably high.
Many, including this analyst, have thrown around the idea that the next natural step, given the incoming weight of treasury issuance, would be for the Fed to implement yield curve control. But on deeper consideration of the issue, we have concluded that the Fed is only willing to control yield out to perhaps three years; note Australia’s RBA is on the same page there. Controlling the entire yield curve is far too drastic in both the scale of intervention into the financial market, and because controlling that much of the sovereign yield curve is to underwrite the sitting government’s political platform – too drastic a step for the Fed. That doesn’t mean that yield curve control doesn’t happen eventually, but it would be on orders from the US Treasury and not up to the Fed’s own discretion. Next quarter is far too early for such a development.
Chart: USD vs. Global Equities and Commodities. It is clear to see from the chart below that a weak US dollar is critical for the performance of global asset prices and real growth, as it is effectively the world’s currency for funding. Note the important directional sympathy of commodities prices with the US dollar, and with that, note the generational low in commodities prices (in USD terms) during the worst pandemic months, as this index bottomed below even the 1998 trough (not shown). Finally, keep in mind that the commodities index is a nominal price series. World GDP in nominal USD terms since that 1998 trough in the Bloomberg commodities index has nearly tripled. Currencies associated with commodities should do well in relative terms for a generation from here.
Meanwhile, the background tailwind for USD bears continues to blow: to wit, the US providing the most fiscal forcing of any major economy, and as the economy that always delivers the most demand into the global economy with its massive twin deficits, the US dollar must eventually turn lower again to keep the global economy on the reflationary track. A strong US dollar is simply too toxic. Q2 is likely to pivot the USD back lower, even if the issues above generate further two-way volatility on the same basis we saw in Q1.
Whether in EM or among the G10 currencies, we are long term bulls on commodities thanks to the drastic underinvestment in the space, made worse by the pandemic – especially the fossil fuel sector. As long as the global economy is emerging post-vaccine in Q2 as hoped, we look for a buy-the-dip mentality for oil-linked currencies like NOK, and CAD to a lesser degree – and for the risk-tolerant, the Russian ruble (RUB). The Australian dollar should continue to outperform in coming quarters.
The CEE currencies look to continue to provide negative real interest rates as far as the eye can see, something we saw heading pre-pandemic as well, as new populist fiscal stimulus programmes boost inflation far beyond the response in the policy rates across the region. The EU will also remain the tardiest in making the coming shift to “fiscal dominance” that has already occurred in the US and UK, pushing less demand into the EU economy, while the new 7-year EU budget has chopped allocations to Czech Republic, Poland and Hungary by around 25%. In Asia, average demographic profiles are more healthy and real returns are likely to prove superior as the Chinese centre of gravity for the region keeps its currency strong and stable relative to the volatility risks to the US dollar from the radical policy shift unfolding in the US.
The euro was quite weak in Q1 and the JPY was abjectly weak in the quarter, as both suffered from their very low yields in an environment of rising yield and growth expectations. The JPY has long been a very long yield–sensitive currency. Indeed, sharp yield rises at the long end of government yield curves elsewhere were only weakly echoed in these two key economic powers’ bond markets, and it was interesting to see the reaction of the ECB and the BoJ to those modest yield rises. The ECB showed its first signs of distress even before 10-year German yields got anywhere close to rising to 0%. And in Japan, a BoJ policy review in March is struggling with what to do with its policy mix after the 10-year reached beyond the top if its range since 2016 briefly (at a mere 18 basis points). If global yields and commodities do continue rising apace from here and these two countries don’t allow their yields to follow suit, it could prove a powerfully negative signal for these currencies. The only thing that offsets that risk is the traditional large current account surpluses these blocs normally maintain, although these will be eroded if commodity prices go into overdrive. The EU is a particularly tricky case, given the difficulty it has with its foundational error of having one currency and central bank and multiple member sovereign debt markets. Coordinating the switch to “fiscal dominance” here will be the most problematic and could keep the EU as a growth backwater or worse for quite some time.
Sterling could continue the surge of strength it enjoyed in Q1, though we suspect the rate of change is set to slow in Q2 as the tailwind from its early vaccination success will slow in relative terms. The UK looks isolated on trade relationships and is suffering post-Brexit birthing pains with Europe that will be tough to sort out. Offsetting that will be considerable capital flows returning to the UK to invest now that post-Brexit lay of the land is known; on the other hand, enormous UK budget deficits and a still considerable trade deficit must be financed.
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