The US dollar is still the centre of gravity

John Hardy
Head of FX Strategy

Summary:  Eventually, the Fed and global central banks are likely to effectively lose their independence as we transition to full MMT.

In our Q2 outlook, written in the heat of the worst portion of the market panic in March, I wrote that “we can’t call a bottom for the markets or peak moment for the crisis until the USD itself has turned”. With the benefit of hindsight, that is indeed what has unfolded thus far, thanks to the Fed’s mobilisation of terrifying quantities of liquidity and an alphabet soup of asset purchases and loan programmes.  

Indeed, 23 March marked both the top for the US dollar and the low for most major global equity indices. Since then, an ocean of central bank liquidity has been poured out to stop the firestorm of contagion, and the USD has returned to its trading range in the period leading up to the crisis.  

Here, on the cusp of Q3, one can’t help but wonder whether March’s market nadir and subsequent awe-inspiring comeback was the beginning and the end of the cycle, meaning we are headed back towards something resembling normalcy. We believe this is highly unlikely. Steen’s introduction to this outlook outlines how our very response to the crisis is eroding the prospect for any vigorous recovery. Instead, the central banks’ reflexive policy of bailing out everything drives zombification, and a political turning inward accelerates our way down the path of deglobalisation.

Sure, we have completed a cycle of sorts. The massive ramping in equity prices – and other risky assets – and pump and dump in the US dollar are products of a liquidity bonanza that has reached its maximum amplitude. From here, the run rate of support for the economy and market will only increase again if we reach another moment of deep crisis. As we get deeper into Q3, we suspect new themes will emerge for global markets and FX beyond the zany risk-on, risk-off gyrations that marked much of Q2 in response to liquidity injections from global policymakers. 

Liquidity versus solvency 

First, there is the issue of solvency, a far knottier problem as we transition through the fallout from this shock to the economy than the basic liquidity and systemic risk issue. The economic recovery over the next quarter and beyond isn’t likely to mimic the V-shaped recovery in liquidity and risk appetite driven by central banks’ balance sheet explosions.  

This is likely to mean more two-way volatility in the quarter to come, relative to what we saw in Q2, and a US dollar – and Japanese yen – that are not set to roll over just yet, at least not consistently. That volatility will come as a function of the normal cycle of defaults that any recession brings, with enhanced risks this time around because of the excesses of the previous cycle. Q2 has already seen record numbers of corporate defaults, an issue that is far tougher for the Fed to address. It may be able to buy a corporate bond – or $750 billion’s worth – but it can’t prevent the underlying company from declaring bankruptcy to restructure its debt.  

Q3 may yet prove too early, but the US dollar must roll over eventually. If nothing else, because we live in a world drowning in USD-denominated debt, both onshore in the US and globally – and any durable recovery has to see a devaluation of the US dollar in real terms in the US and in relative as well as real terms (think exchange rates) in the rest of the world. The risk of widening insolvencies and defaults will encourage an outright devaluation unlike anything seen since the post-World War II debt devaluation and the 1934 Gold Reserve act. In the latter of these, the US government devalued the USD from $20 to $35 per ounce of gold. 

The chief question is the time horizon, but Q3 will see pressure mounting on this front. Eventually, a devaluation will be achieved through the Fed more or less surrendering independence. How? By enacting yield caps, or some other form of yield curve control, to allow fiscal spending unconstrained by considerations for whether “the market” can absorb the usual sovereign debt issuance used to finance spending.  

US Presidential Election to loom large for the USD and global markets

President Trump’s mishandling of the twin crises of Covid-19 and the anti-racism protests triggered by the police murder of George Floyd have him sagging badly versus Democrat Joe Biden ahead of the 3 November US presidential elections. The changing of the guard in US politics is often a momentous occasion for financial markets, due to changes in taxation and other policies. With fiscal primacy taking over and central banks increasingly losing their independence, and because the odds are tilting increasingly in favour of the Democrats taking both houses of Congress, the election in 2020 election could prove easily as large of a gamechanger as it was in 2016.  

We’ll have more ink to spill on the election in next quarter’s outlook, but anticipation may rise steeply over the next three months and serve as a considerable headwind to the USD. A Biden presidency could see rising taxes, a climate agenda, minimum wages and other policies hitting corporate bottom lines and the relative attractiveness of US assets. This, even as his administration would look to expand spending on infrastructure, health and other areas that boost inflation. 

Currency volatility to rise via currency wars and fiscal primacy 

The Fed and global central banks have managed to win round one in hoisting asset prices and avoiding the immediate asset market fallout. Eventually – most likely in Q4 after the presidential election – they are likely to effectively lose their independence as we transition to full MMT, or a similar regime with fiscal supremacy. Such a regime will aim to drive nominal growth higher at all costs to prevent the rise of the debt load in real terms – in short, financial repression. This will be best for hard assets, commodities and some equities and bad for fixed income.  

In FX, the losers will be the currencies with the worst financial repression and most aggressive MMT programmes. The relative winners will be economies with significant commodity potential. Current account considerations will also loom larger than they have in the past due to deglobalisation, slower trade and possibly reduced capital flows. 

Many of the issues listed above are likely to entrench themselves in the narrative and market reality beyond the next quarter, with Q3 perhaps largely proving a transition quarter. Unless, for example, Biden’s lead in the polls clearly widens and makes it easy to call the election. Whenever possible, markets like to operate on expectation rather than the current lay of the land.  

Looking away from the dominant focus on the USD, Q3 will also likely establish whether the EU is showing enough solidarity to avoid a fresh round of existential concern. Signs were more promising than expected in Q2, after German Chancellor Merkel changed her tune and agreed more exposure of the German balance sheet to EU-wide spending.  

But the EU budget response looks modest and late relative to the scale of the crisis, so this glint of promise will need to deepen significantly in Q3. Tighter spreads across the EU and growing signs of solidarity are required if we’re to lay our longer-term fears of a new EU existential crisis to rest. 

Above all, given how wrong the consensus was about the shape of the market recovery in Q2, we keep an open mind on how Q3 might shape up, with some risk that the liquidity response was so overdone that the Fed has created a new bubble. Stay careful out there. 

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