“I'm the voice inside your head you refuse to hear..."
- The Pretender, Foo Fighters
For many months (quarters) now there has been a small but consistent collection of themes running through our thoughts and comments:
i. The differentiation of the global recovery from the pandemic (unlike the synchronous global recovery from the global financial crisis) – not only in terms of chronology, but also in terms of magnitude, dynamism and sustainability (even self-sustainability).
ii. Inflation will ultimately prove transient.
iii. Growth and yield differentials likely increase attractiveness of US assets and the USD.
All of these factors remain relevant and we would argue dominant in the current environment.
Consensus views, however, remain aligned to USD weakness.
Following the Federal Open Market Committee (FOMC) meeting in June, our thoughts (Going Up?) were clear. We suggested at the time that this marked an important pivot for Federal Reserve (Fed) policy, not necessarily due to the upgrades to the growth and inflation forecasts in the Summary of Economic Projections, nor indeed solely as a function of the revised ‘dots’ which showed not one, but two rate hikes in 2023. Rather, for us it was the confident economic narrative and its implications for the Fed’s reaction function. The ‘strong’ job creation, the ‘very healthy’ economy, the ‘very, very strong’ demand and the ‘solid’ pace of business investment – the default was no longer to err on the side of the fragile economy. As I see things this was the meeting that witnessed the Fed realign its reaction function towards policy normalisation (albeit gradual), as opposed to the market expectation of remaining intentionally behind the curve. In doing so the focus arguably shifted from inflation to growth – more specifically from the risk of the Fed stoking inflation towards a Fed that is confident enough in the growth backdrop to begin to remove some of the accommodation.
This Fed pivot in June is not only clear and obvious in charts of the USD relative performance, but also in the correlation of assets. Until this point, global equities (YTD performance) had been broadly aligned – since the June FOMC, US equities have seen a marked outperformance. Furthermore, the USD was highly correlated to US long real interest rates - this correlation subsequently reversed. All of this is consistent with a move to the right-hand side of our Dollar Smile Framework where economic outperformance can drive a strong USD through global capital flows. From our perspective the US – and thus the USD – can continue to outperform. In our writing following the June FOMC we suggested that normalisation is in train, so too perhaps is USD strength.
Since the June FOMC we have also seen a raft of global central banks turning more hawkish. Most notable are the Latin Americans and other emerging markets that have been keen to get ahead of both the Fed and inflation, but recently we have also seen quantitative easing (QE) reduction (twice) from the Bank of Canada, and an early end to QE from the Reserve Bank of New Zealand. This week we have even seen the unexpectedly hawkish commentary of three Bank of England (BoE) members – all suggesting the possibility of ending QE early and even raising the policy rate (so much for the hawkishness of the BoE leaving with the former Chief Economist!). All of this is important in our view as it links two of our themes (i and iii). It does not likely counteract USD outperformance, but it does likely lead to greater differentiation – especially within the currency space.
There is another live debate in the market at the current juncture – the rationale or inference of the lower flatter US yield curve. While many look for negative prophecies about long run US growth expectations, we have a different view. The US Treasury market has the enviable position of being the funding structure for US domestic finances and a medium for global safe haven flows. At the current juncture we feel that there are three factors suppressing the US yield curve:
i. the world still has a shortage of positive yielding safe haven assets.
ii. Covid resurgence across the globe means that uncertainty remains high and thus safe haven demand is high.
iii. Domestically the US is generating a near unprecedented cash glut; a huge surplus of cash that has exhausted money market yields and as such has sought greater duration in the hunt for yield.
This ‘inherited’, not earned, lower yield curve likely further benefits the US – a yield that is lower than would naturally be benefits individuals and companies alike and ultimately likely contributes to further widening the US growth differential relative to the rest of the world.
This demand led suppression of the US yield curve (aided by the view that inflation is ultimately transitory) is not ‘a harbinger of impending doom of the US economy’, or a prophecy of an uncomfortably low r* on either weak future growth or the inability of the Fed to hike (for whatever reason). Instead it is likely further fuel to US growth, US assets (particularly equities) and ultimately the USD.
DXY (mirrored by EURUSD) is currently sat at a potentially significant technical pivot level which by our analysis could have a technical target of 1.1100 in EURUSD. Meanwhile, the EURUSD volatility surface appears priced for a summer of inactivity!
It is not clear what the trigger will be for the next leg of USD appreciation. It could be further progress on the renewed talk of US infrastructure projects. It could be a sharp pick up in US labour market dynamics – fostering more imminent direct taper talks. Whatever the reason, from my perspective at least, it feels as if the market is unprepared, unaware or simply refutes the prospect of a higher USD from here. Either way, I see a far more eventful summer for the USD than the market is currently contemplating.
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