USD bulls and bears may be in for a rough ride in Q4

John Hardy
Head of FX Strategy
The backdrop going into Q4 looks challenging for any smooth continuation of the USD sell-off. US political dysfunction and the risk of a contested US election will have the market holding its breath until election day. Post-election uncertainty, meanwhile, could drive a fresh spike in two-way volatility across markets and lead to many a false start for USD bull and bears, possibly into the New Year.

In Q2, the Fed and the US Treasury’s twin howitzers of easing and enormous cash drops on the US economy helped turn a spiking USD back lower, and early Q3 saw a continuation of that move. That took the US dollar to levels around 2-3% below its pre-virus range. The USD sell-off began easing in late summer, though, as the Fed stopped growing its balance sheet on a surprising strong growth rebound and the path to further fiscal stimulus was blocked by US political dysfunction. This theme is likely to persist for much, if not all, of Q4. Another contributor to USD resilience in Q3 was that the US found itself with plenty of company as Covid-19 resurgences popped up nearly everywhere, especially in Europe, threatening renewed anti-virus measures there and hampering tourism for Club Med.

As Q4 rolls into view, the spectacle of the US election dominates the horizon for traders across asset classes. The lessons of 2016 are preventing strong market confidence in the outcome – with trust in the polls one very prominent issue, as Anders points out in his excellent piece. The novelties of this election include its patchwork of different state voting systems – many of which will be expanding mail-in voting far beyond their accustomed capacity – as well as the unknown of how virus considerations will impact voter turnout across different demographics.

One thing that is less likely to repeat this time around is the decisive clarity that emerged in a matter of pivotal minutes on election night in 2016. Then, it became clear that Trump would win the election and both houses of Congress, which would enable him to pursue a full-fledged anti-regulatory, tax-cutting, growth agenda.

Between now and election day, it will be supremely difficult to extract a signal from the noise and for the market to put much confidence behind its election predictions or US-dollar view. This could lead to choppy trading until at least election day, with the strong risk of a contested outcome – and the back forth headlines that would come with it – amplifying volatility until a victor emerges.

Poisonous partisan politics is holding up new stimulus for those who have lost the most in the ‘K-shaped recovery’, and are at risk even on the level of food security and eviction from their housing. As we are writing this outlook, the showdown over whether Trump will nominate a very conservative new Supreme Court Justice to replace the liberal Ruth Bader Ginsburg is even threatening a disastrous government shutdown.

These disruptions, when the economy and so many of its participants are dependent on support, are negative for the greenback and invite further Fed easing. But then again, a potential government shutdown and weak risk sentiment both tend to support the US dollar. The JPY might be a strong winner across the board in the worst-case scenarios for the US election, and showed signs of coming to life after a long period of dormancy with the announcement of Shinzo Abe’s exit in September.

Contested election or a strong Biden win?

The chief difficulty when analysing the market impact of the 2020 US election is that no scenario leads to an immediately obvious outcome. 

Some might see the reaction to a Trump victory echoing what unfolded in 2016, when the USD surged on the anticipated pro-growth agenda, as such an outcome avoids any threat of heavier regulation or the raising of corporate tax rates that Biden has promised. But if Trump wins by a narrow margin with a repeat of 2016’s popular vote loss, it could lead to social unrest unprecedented since the 1960s. Democrats could cry foul over charges of voter suppression and Trump’s style of zero sum politics, which has supercharged animosity on the progressive left. The backdrop of ‘choose-your-reality’ media outlets and toxic social media also weighs in the mix.

Equally, a Biden victory without the Democrats taking the Senate – entirely possible if Biden’s win is a narrow one – will keep the partisan stand-off firmly in place and prevent Biden from realising any portion of his party’s platform.

So, a contested election is neither here nor there for the USD but gets more USD negative if the situation turns ugly and spills into 2021. And a narrow victory by either party without both houses of Congress is also USD negative as Congress won’t pass anything and the Fed will have to challenge the outer extreme of its mandate – and beyond – to support any recovery.

As of writing in late September, a strong Biden victory and the return of the US Senate to Democratic hands does appear to be the most favoured scenario, even if an overwhelming margin of victory is likely needed to avoid a week or more of Trump contesting the election.

Here, the reflexive logic that Biden with both houses of Congress is bad for the USD may not prevail. Select US assets will be hit negatively by a Biden victory, as discussed by Peter Garnry in his outlook for US equities. But a Democratic clean sweep is likely to lead to a very powerful fiscal impulse that will drive the demand side of the US recovery far more than Trump-style deregulation and tax cuts ever could. This approach eventually drives inflation and even stagflation, but could actually lead to a stronger US dollar for a quarter or two first. Biden has promised tax raises for corporates and high earners, and we shouldn’t forget that Democrats have been far more fiscally prudent than Republicans in recent decades.

Aside from the intense focus on the US election and its implications for the US dollar, the dominant issue hanging over everything is of course Covid-19. Specifically, whether the coming of fall and winter will bring an resurgence in infections and whether a younger demographic, better treatment or a mutating virus are the drivers of the apparent reduction in the fatality rate.

If vaccine candidates are not beginning to show promise at the end of 2020, we risk a deepening second dip in the global growth outlook. This will put an enormous dent in the reflationary narrative that purred to life in Q3, amid recovering commodity prices and support for commodity-linked currencies in EM and DM.

The path to a traditional global reflation trade, driven by a weaker US dollar and fresh credit cycle, will be frustrated as long as the virus continues to hold back the demand side of the economy and as long as fiscal authorities fail to force inflation high enough to outpace the real load of global debt. The initial policy response to the Covid-19 crisis only added perilously to the growing pile.

Brave new world of FX?

That brings me back to some thoughts I aired in April, when outlining a framework I described as the ‘brave new world of FX’. I tried to anticipate what would move exchange rates over the medium to long term in a world where central banks have flattened rates more or less to zero, and where they are even threatening – or have already started – yield curve control (YCC) on top of QE.

The point of a QE-plus-YCC policy mix is the avoidance of price discovery for the price of money. It is the great enabler of fiscal policy to do whatever it wants, only limited by inflation, as governments will increasingly discover. In that future, the chief fundamental that matters is the real interest rate – which goes negative when inflation exceeds interest rates on government paper. With no price discovery in government bonds (central banks must always ensure that governments can fund themselves as an all-important first priority), discipline is only enforced by the exchange rate – perhaps the last valve for price discovery down the road. In short, in a world of fiscal forcing, FX volatility could expand significantly.

As a footnote, the Fed’s new ‘Average Inflation Targeting’ policy is a preannouncement of its own irrelevance and really just what it thinks it should have done in the last cycle. The US government and other governments globally will begin to flex their MMT muscles to deal with the ongoing fallout from the Covid-19 disaster, only stopping when inflation and exchange rate considerations become too painful to bear. A country that doesn’t want to play the game suffers the consequences of excessive currency strength: eventual erosion of export industries, domestic asset bubbles and more. Welcome to the brave new world of FX.
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