Outside the Box

US Dollar: American Phoenix

March 24, 2015

 “Just a little patience, yeah…”

– Guns N’ Roses

Lastweek the FOMC essentially removed forward guidance and placed all options back on the table, and at the end of the day they’ve opened the door for further tightening. As Yellen recently explained in advance, the removal of the word patience from the Fed’s guidance amounts to fair warning to the rest of the world’s central banks: an interest rate hike is on the horizon. Govern your actions accordingly. (My personal guess, for those interested, is September, with the Fed proceeding exceedingly slowly and cautiously thereafter.)

The bigger story here is the sustained strength of the US dollar, which has traded wildly in the FOMC’s wake. A correction to the one-way trading prior to the meeting was well overdue and could last some time, but then the dollar strength will resume. (Euro) Parity or Bust! My young colleague Worth Wray and I have been writing for some time about the risks this trend poses, to emerging markets in particular, and now it seems that nightmare could  happen sooner rather than later.

We’re already seeing profound FX pressures on countries like Russia, Brazil, Turkey, and South Africa, among many others; but, while clearly exacerbated by the strong dollar and/or weak commodity prices, recent stress in various emerging markets appears to have more to do with internal troubles than external shocks. Nevertheless, the dollar’s strength has not been fully absorbed by EM economies, so a BIG, broad-based, dollar-driven adjustment may be yet to come.

Until this Wednesday’s FOMC press conference with Janet Yellen, the growing consensus was that an eventual interest rate hike would lead to an even stronger USD. Now it seems most observers, including our own Jared Dillian, are doubting that a rate hike will come this summer… or anytime soon.

Worth and I have a different view. We believe that Federal Reserve Vice Chair Stanley Fischer has carefully laid out a framework for interpreting the FOMC’s opaque communications as the committee moves closer to a rate hike. In a speech last October, Fischer made it clear that the Fed would “recognize the effect of (its) actions abroad and … minimize the negative spillovers (those actions will likely have) on the global economy” by clearly communicating its policy intentions in advance. If you read between the lines, the only way the Fed can give foreign central banks the opportunity to prepare for the likely FX shock that would follow a rate hike is to send the message in a way that the market does not immediately understand as overtly hawkish. This week’s announcement makes perfect sense when looked at through that lens.

Translation: while the FOMC’s decision to hike interest rates remains data-dependent, the Fed has opened the door for further tightening as soon as June 2015. That could be terrible news for a number of emerging markets, but none of those countries can credibly complain that the Fed is responsible as capital flees their economies in search of safety and more-attractive risk-adjusted rates. Emerging markets are not a homogenous group, but even the best positioned countries like the Philippines are at risk in the event of a broad-based contagion. We’ve seen that dynamic play out repeatedly in the 1980s, the 1990s, and the 2000s. It may be time for another hurricane.

With our expectations on the table, Worth and I still have to ask… what if we’re wrong? What if the dollar doesn’t strengthen? We’ll consider that scenario in today’s OTB.

It’s a real pleasure for me to introduce today’s author, because this OTB is also the perfect opportunity for an announcement I’ve been wanting to make for some time: Jawad Mian has brought his excellent research service, Stray Reflections, to Mauldin Economics. You can learn more about his service here. His “transparent hedge fund” approach to investment research is unique, well-reasoned, and decidedly non-consensus. And his prose is unrivaled.

Today’s OTB is taken from Jawad’s top 10 investment themes. These are the themes around which he builds his portfolio. I agree with many of his ideas, but I offer up this particular piece as an example of one where I remain unconvinced, if not in outright disagreement. Yet… Jawad makes such a strong argument for the dollar’s weakening. We have exchanged emails and dueling notes of late (but in a very collegial fashion).

I have to admit, I am NEVER comfortable when this much of the crowd agrees with my view, as they seem to now. A serious correction of the recent trend in dollar strength is clearly due, but what if – as Jawad argues – we are seeing a major shift to an entirely new macro regime?

It’s worth noting that Jawad made this weaker dollar call several months ago. HSBC analysts and others are beginning to agree with him. The US dollar is the single most important factor in global macroeconomics; so do your homework, consider the antithesis to your closely held beliefs, and ignore Jawad’s thoughtful analysis at your own risk.

I was in Switzerland for the last week, meeting clients and speaking in Zürich. I kept asking the question, “Where is Draghi going to get €60 trillion in European bonds, month after month?” He is reportedly already behind the curve for this month’s purchases. I get no satisfactory (to me) answer. Maybe he does, but he wants to buy more than governments are issuing, and no pension company or insurance company is going to be able to sell him their bonds if they have a positive yield. Maybe he gets creative in what he buys. I will write more about this over the next weekend, but we are in the Twilight Zone for bonds. French yields are negative out to five years, and to get 1.5% you have to buy a 50-year French bond? Can anyone do that and seriously be considered a prudent fiduciary? Have you looked at France’s balance sheet and total commitments, not to mention the country’s politics? And don’t even get me started on the rest of Europe. Half of Northern Europe’s debt has negative yields.

I had the very real privilege of having dinner with William White, former chief economist of the Bank of International Settlements and currently consultant to seemingly everyone. He will be at my conference this year as the final speaker, and it will be a very impactful speech. On several occasions during dinner, I got him to agree to say in public what he said in private Tuesday night. I have long been a fan of his candor and style, and that evening I felt like a student. He is now my favorite (ex) central banker.

I want to thank so many of you who wrote to me expressing your condolences about my Mother. It meant a lot. Truly.

My sister flew in from Victoria Island, where she lives with her sons. I cornered her the first night she was there and told her that her other brother wanted us to sing at the graveside the lullabies that mother sang to us as children when she put us to bed (and which we all vividly remember). I tried to convey the clear impression that I thought it was a bad idea, but I was amazed that she agreed with him. “I think it is a marvelous idea, and mother would agree. You will do it.” How can you tell your little sister no when she looks at you that way? So, there I was, singing in the rain, or trying to. I don’t think I actually made it to the end of “Tura Lura Lural.” In the moment it was much more than an old Irish lullaby.

Your doing a lot of pondering analyst,

John Mauldin, Editor
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US Dollar: American Phoenix

By Jawad Mian

A New Religion

Divergent monetary policy, interest rate differentials, and growth trajectories favor the US over Europe and Japan. This has become the key investment theme for global investors. Foreign flows into US financial assets hit a record last year while traders’ speculative long positions in the dollar reached a new all-time high. It is believed the US dollar has begun a…

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timsimmonds35@gmail.com

Yesterday, 8:21 a.m.

The value of a currency is relative to it’s pair/pairs.As such any analysis has to include a study of the other pairs.The dollar Bull story is not just about the U.S. economy.

mike_bradley@mentor.com

Yesterday, 4:28 a.m.

While I can understand the FED would like to bring interest rates back to reality, fundamentally I don’t understand how they can do it in the short term as:

  * US interest payments on new debt go up (I have to assume the FED cares at least a little about the deficit).
  * FED must know the economy is weaker than the media reports
  * Deflationary tendencies.  Would not higher interest rates be more deflationary than lower ones?

So, what real motivation would the FED have for raising interest rates?

fairnooks@yahoo.com

March 24, 5:14 p.m.

I think Jawad’s reasoning is sound, except it seems more applicable to normal market forces…which are so manipulated these days by Central Banks. When that control, real or imagined disappears, all bets are off. As you say in the article, what if Draghi can’t pull off the Eurozone’s version of QE? What a disjointed mess the Eurozone is…the dollar and U.S. economy is not as strong as it’s become historically but how is it doing relative to other currencies and economies at present would seem to be a better measure. Also, “The most important chart” is nothing of the sort because it has been pointed out several times that there seems to be very little that actually does follow the rise and fall and further fall of rates other than initial emotional reaction.
May we live in interesting times eh?

Jack Hiller

March 24, 5 p.m.

J. Mian,

Your facts, such as they are, are well selected to make an argument that the Fed risks creating a USA recession, or worse, with any campaign of short term rate increases while the economy is weak, wage growth is poor with low wage, part time jobs prominent for the “new jobs,” and with Japan, the ECB, and China (if quietly) outcompeting the US with lowering interest rates and devalued currencies. So, it would be rational for the Fed to make no more than two small rate increases for show, and stop. So far, so good in your argument.

However, you need to specify the other currency or currencies that will become more attractive than the USA dollar—China, with a real estate bubble, Japan with a declining population and staggering debt, the ECB also with a declining population, high debt, and a Capital erosive Socialism?

This awful phrase directly explains why the dollar will remain strong, and likely be gaining for years—“Best darn horse in the glue factory!”

R. Blum, You really believe that the socialist/Communist dominated cultures of Brazil, Russia, India, and China offer a more honest, safe and secure banking network and currencies than the USA? Well, I was born in NYC, and I know of a dandy bridge waiting for a sharp buyer, but I myself lack the cash.