Macro Reflections: Imagine a GFC-Like USD Spike of +26%...
Global Macro Strategist, Saxo Bank Group
Summary: We take a look at the potential, lack-of strength that the US dollar has seen so far in this crisis (+8% from lows to highs), compared to the +27% it did during the 2008-2009 financial crisis. With the strong dollar, likely to be bid until the Covid-19 contagion has been solved on a global level - one big thing that the US Treasury, FED & of course G7 finance minsters could do, is to orchestrate a structural USD devaluation - to bring down the significant choke-hold & headwind that the US dollar is creating for EM countries. If such a scenario were to play out, KVP favors gold, OTM lower strike puts on DollarYen & OTM high strike calls on Cable to capture some of the biggest gains.
Macro Reflections: Imagine a GFC-Like USD Spike of +27%...
- For those who may no be in the know, either through not swimming in the waters of the currency market, or had gotten into the markets post the GFC… its worth checking in on the USD.
- There has been a lot of focus on USD strength during the Covid-19 Crisis & economic fall-out that we are going through globally (with pockets such as China & Taiwan now being through the initial storm).
- A lot of this steps on the perpetual US dollar shortage, that is a state of the affairs on how the global pluming of trade, capital flows, markets & financing work in the world. The bottom line facts are: the USD is the global reserve currency, it is the biggest economy at c. $21trn (Jan 2020) at c. 25% of Global GDP, it has the biggest, most liquid & free equity markets at c. +$30 trn & debt markets at +$40 trn (just c. $15 trn in US government bonds alone) [Note some of these figs may be a little off given the correction from Jan 20 – but bottom line, no other country comes close]
- Meanwhile it estimated than up to 60% of global debt is issued in USD, which makes sense for investors not wanting to take currency risk on foreign countries. On top of all this, the USD is the default currency on the pricing of commodities, global payments systems, etc. Its circumstance of colonial global power transfer of the reserve currency – sterling to USD post the WW – as well as just a construct of a lack of alternatives that are better.
- The whisper number on the USD shortage out there is $ 15 trillion (3x the size of Japan’s Economy, which is the 3rd largest in the world after the US & CH) – a very strong USD, especially when the world is undergoing stress, is like a tightening choke-hold on emerging markets economies. With a few of the contrarian beneficiaries being those with debt & operating costs in local currency, yet have revenue in USD (commodity players normally fall into this bucket, yet sometime players in the travel & tourism also operate on this business model). Yet the majority have the inverse, rev in local currency & debt, as well as interest expense in USD.
- The DXY closed last wk at 99.782 -1.1% for the wk. During the Feb-Mar periods of intense risk off we saw the DXY go from lvls of c. 99 to make a low of 94.65 (key date 9 Mar 2020, say day we saw the 1703 in gold, 31bp on US 10s & oil closing down -25%).
- It then too off like a rocket ship climbing c. +9% to this 3yr highs of c. 103. We then got a lot of shock & awe, historical measures that also included a global network of swap lines to central banks that qualified. Since then (&in conjunction with the bounce up in credit & equities), the DXY pulled back by about -4.6% to 98.27. We then climbed +2.7% 100.93 & are now -1.8% at the se c. 99 lvls.
- Looking back at the 2008-2009 GFC period, we initially had a big spike of the DXY, before it pulled back & went to make new highs. The run from lows to highs was c. +27%, which would imply a potential 120 lvl if that situation was to play during this Covid-19 crisi, basically +20%.
- Whilst that scenario is a much lower probability than would have been the case a few wks back. The USD is likely to still remain bid, until we get the humanitarian & monetary relief that is screaming from the EMs & FMs. Any signs of significant further market corrections (-5% to -15% on the S&P), are almost certain to see an upward spike in USD strength.
- Whilst the risk-on appetite continues to hold in the equities & credit market, then the USD is likely to be offered & stay around these 96 – 100 lvls.
- One big thing to keep in mind – a structural devaluation of the USD, whilst having its share of costs, would likely still be net beneficial to the global economy & EM in particular. Its easy to argue the point on why would exporters such as Europe, Japan or China agree to a weaker USD which could only occur with their currencies strengthening – i.e. making their exports more expensive – yet this fails to factor that if parts of the world (EM) are not given less structural headwinds now, there is going to be longer term deflationary consequences from the form of future demand from these EM countries.
- Basically, you can argue about a decision making your goods more expensive to sell in the global commerce system, yet bear in mind that your goods are as good as worthless if there are no viable participation in the global system of commerce.
- KVP thinks the probability of an orchestrated USD devaluation is a higher probability than the market thinks. Initially he was of the view, that we had to get a lot stronger USD to get there – yet given the speed & magnitude coming out of the US Treasury / Fed / ECB, etc… its no doubt a scenario that is being entertained.
- Trump would be the paragon of supportive, he has complained about a strong dollar for years & this would be a great win to take into the November presidential elections.
- How would KVP position for this potential scenario? Gold is the celestial call here… it has the multi-year (decade?) debasement theme going for it once the Covid-19 storm has settled & is likely to see 2000 easily before the year is out. A USD devaluation would be an epic booster for gold, which should climb quite well on a much weaker USD & a world where not only are yields significantly lower than where we were 3m ago, but they are only moving lower.
- From an FX perspective…. Yes EUR, CNY, JPY, GBP would benefit – KVP would prefer the latter two. Both through OTM puts on DollarYen & OTM calls on Cable - which with Bojo out of the hospital, no longer has near-term significant downside risk from a loss of key leadership perspective.
- Obviously US exporters (be it through their equity or credit) would also benefit tremendously here - granted we are not going back to a freeflow trading world of Jan 2020, until well into 2021, perhaps even 2022 if we are talking about areas such as global tourism.
- A structurally weaker dollar would take out a significant headwind on EM assets, be a boon to US exporters (Trump), would also lower volatility & help make a bullish / “we have bottomed out case” that much more clearer on a global level.
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