What if the Dollar is a "Solved" Problem

Sections: 

- Markets in two times frames

- Is the dollar a solved problem

- Relative FX vols, change in regime

- A lot is happening in China, what if CNH strengthens

Markets in two time frames

One of the things that is very interesting to me at the moment is, the current macro risk setup seems to be occurring over two different time horizons. Yes, markets are bid again, but really spoos have been stuck in the 3100-3120 area for the past week now.

In the near term, the macro setup seems to have a few headwinds. Reintroduction of mitigation measures in Beijing, rising positive test rates across the south/west in the US, rising possibilities of W's across many high frequency indicators and pending fiscal cliffs most notably in the US.

However, over the longer term, there are some very bullish things happening. One, the dollar is appearing to look like a solved problem (will further explain this below), at a minimum, the Fed has nipped the $ feedback loop in the butt. Second, the European recovery fund is not perfect but it is a paradigm shift in terms of fiscal transfers and expands fiscal scope for the periphery. Third, it seems like there will be a vaccine, and with the discount rate at 0, the waiting game is doable. And lastly, maybe most importantly, the global economy's fiscal posture looks like it could outlast covid, which either changes the distribution in terms of pricing demand shocks, or best case, leads to a bit of a demand side revolution where governments transition from economic cushions to economic accelerants. Either way, the skew is positive.

With that said, the path there will be messy and likely will entail multiple retests. In terms of equities, one of those levels that has been of great interest to me recently has been 2950 area in S&Ps. That is where, the rally shifted from tech led to cyclicals led. Now, as the rise in new cases accelerates and some of the promising high frequency data appears to be showing signs of rolling over, tech has reestablished itself as the leader of this rally. If we stay in this current environment, especially with a fairly nasty quarterly rebal on the horizon at month end, S&Ps should be biased lower over the next few weeks. After that, the debate in price action returns to, how long will this fiscal impulse be with us. If it is temporary, tech by itself can keep the major averages fairly elevated, likely above 2850 in S&Ps. However if this fiscal impulse will transcend covid, multiples look a lot less scary and equity risk premia will continue to be taken in. To me, the balance of risks is, going into potentially slowing high frequency data and fiscal cliffs (end of July), the market will have a tough time absorbing quarter end, however, once the fiscal impulse globally is clearer and sustainable, the market will have little trouble discounting a turbulent fall in terms of the virus.

Is the dollar a solved problem? 

I want to preface this section by saying, this is not an all clear on selling the dollar. However, there is something very interesting about the dollar backdrop that could have massive global economic implications. The question for the dollar has shifted. Given the Fed backdrop and potential for sustained synchronized global fiscal expansion, the question is not what if the dollar has an ugly break higher, the question now is, what is the catalyst that turns the dollar into 2017 mode and trend weaker.

Dollar liquidity has gotten a bit interesting again. Bill supply, huge TGA cash balance, first swap line maturities, slowing swap line operations etc. The thing is, the counter measures are already in place. Between the CB program at OIS+25bps and the repo program, stress should be under control, as the combination of these programs should keep the market liquid and balanced.

In March, before the Fed expanded its CB swap program, I did a post on why the Fed might be challenged this time around in terms of arresting USD strength. The main reason was, this time around, the dollar crisis was not really on the sovereign or banking side, it was in Asia non bank financials and EM corporates.

So the question was, could the Fed properly downstream dollars to these actors. The answer has been, yes they can.

1) In the face of very lengthy and credit intensive supply chains, trade finance has become very important part of the global trade process for global value chains (Bruno, Shin). The fear was, as eloquently put by Agustin Carstens from the BIS, central banks do not have direct levers to address NFC's financial stress as they have for banks, making support measures more difficult. These GVC's are all over the world, and even for the ones in countries with swap line access, getting the dollars downstream is technically difficult, especially in a stress episode. So the question was, given the links between trade finance and the broad dollar (Shin), could the Fed prevent a spiral.



2) In terms of the maturity transformation trade, it was no longer European banks doing RMBS, it was Japanese life insurer's funding in the front to buy US credit duration. So not only did the non bank sector become a bigger player in the FX swap market, it ended up dwarfing anyone else, especially banks, which in Japan do a lot of funding in USD. 

So the Fed had a real job on their hands, would they be able to effectively downstream USD throughout the global financial system, and into what was a much more complicated backdrop than 2008/9, as many of these players didn't have direct access to swap lines.



Now where are we. Well, with regard to pretty much every concern listed above, the counter measures are already in place.

If March dollars need to be rolled, they can at Fed price. If the trend continues, and there is less need to roll those dollars as a lot of the late March take up was preemptive, then some money could come out of the FX swap market; or if bill supply nudges unsecured, then repo take-up rises and the fire is put out. Basically, between swap line and repo operations, the Fed has capped problems in the FX swap market, which in sharp dollar moves has been the fulcrum place where stress shows up. So if the FX swap market is not going to be under stress as the Fed has basically created the best wack-a-mole player of all time by effectively turning most large gov't bond markets into dollars (Pozsar), the dollar shortage is gone. And, if Fed policy is to try and run a hot economy, pulling the swap lines early or hiking the rate to OIS+50, wouldn't be in line with the rest of their policy bias. The Fed won't be keen to have the dollar feedback loop or relative demand for US assets upend any signs of an economic recovery.

The next aspect of the positive dollar narrative has been, it's the other side of important currencies that have negative skew, namely, CNH and EUR. The market has been obsessed about risks such as, Chinese devaluations and European fragmentation. However, if we look at both of these risks relative to March, a lot has changed. Europe's attempt at fiscal transfers may not be perfect in terms of size or composition, but it is a game changer in terms of precedent. Grants via the Commission innately expanded fiscal scope for the periphery and as we have seen with APP, it's easier to make it larger than it is to start it...... Is Europe fixed, no, should EURUSD trade below 1.08, where it was when fragmentation risk was very real, also no. China is bit more complicated, but the policy backdrop is not for CNH weakness. Interest rate differentials aside, the risk of tit for tat tariff/CNH depreciation is over. Could the White House turn on the heat going into the election, possibly but there is very little sign of that. Now the question is, would China want a weaker exchange rate in absence of US trade pressure. That also seems very unlikely. China has prioritized financial opening up and as China has learned, the policy response to excess savings is not a weaker exchange rate.

To conclude: none of these things necessarily mean the dollar is about to weaken in a significant way. What it does suggest, the scope for another sharp and aggressive rise in the dollar is very unlikely.  Between the Fed playing wack-a-mole with CB swaps and repo in the FX swap market, Europe is not falling apart and China is not pursuing a weaker currency, the dollar seems like a solved problem. Now, this does not mean some of these recent moves in EM can't get vicious again, they can. Latam FX especially looks vulnerable with covid fears back in the fold, murky politics and very little defense in terms of carry. The bigger question now is, what is the catalyst for the dollar to have a sustainable move lower. The answer is, as it usually is, global growth and that will in all likelihood be a function of the global fiscal impulse post covid. What is interesting about this though, if the dollar is a "solved" problem, then the left tail in betting on some of these outcomes is significantly reduced. The problem of the last decade has been, betting against US economic outperformance has been a losing one, however in this dollar backdrop it becomes interesting again even if its not the right bet for the next few weeks. The skew for USD has changed, and if that is true, that is a massive macro development.

If the dollar is biased lower, breakevens should be biased higher.



Paradigm shift in relative FX vols?

For the past few years, it has made sense that EURUSD vol has traded inside of USDJPY vol. However, I wonder if that is beginning to change and Euro vol begins to trade outside of Yen vol. The US election makes this a bit murky I guess, but we should regime shift with Euro trading higher vol than Yen. Yen is stuck between cheap dollar funding and GPIF flows. EUR is actually in a make or break moment that it seems like they may just make. With that said, it is very reasonable to see outsized Euro moves given the backdrop of this inflection point. However, where is Yen going given how stable the FX swap market will be and the Fed put is in the market they care most about, investment grade credit.

Overall, it is much easier to imagine an outsized move in Euro over the next year than it is in Yen, given it will likely just be an oscillation between moving hedge ratios to make sure USDJPY stays in the 105-108 area.




A lot is happening in China, what if CNH strengthens

There seem to be a few independent things going on in China that are all quite interesting.

1) The reemergence of mitigation steps in Beijing caught the market a bit offside. Just as a lot of high frequency data was suggesting some level of normalcy was returning to the capital, electricity production in the first ten days of June was the highest it has been since start of the year. Now, the ERL (emergency response level) is back at level 3 and the risks of a "W" have risen. While the number of cases are still low, and track/trace should keep spread under control, this seems like a big blow to a broader resumption in consumption activity, which was already severely lagging the industrial side of the economy.

2) Liquidity in China has been thin to say the least. Following on what appeared to be signs of liquidity marginally improving, MoF brought down the house with massive SCGB issuance that just zapped liquidity from the system. This has jammed the fixing in rates higher and led to a severe sell off in CGBs and NDIRS. The question now is, into surely another RRR cut, and efforts to get liquidity into the system, is the move fade-able. This question is especially prevalent if current activity indicators are going to turn lower in the near term on the back of mitigation measures in Beijing.

3) Chinese foreign policy has been busy. In the span of one week we have seen, alleged Australia cyber attack, clashes on Sino/Indian border in the Himalayas, airspace intrusions in Taiwan, flair ups in the DMZ and of course HK national security law. And in the backdrop of all of this, a meeting with the US in Hawaii. Is China taking advantage of something or are they trying to divert attention from something more meaningful. This space seems worth watching.

4) Chinese tech stocks are flying and back to crushing industrial beta. Chinese tech is even outperforming US tech since the beginning of June.

To be honest, I have not been able to put all of these things together. With that said, to me, USDCNH is getting very interesting. The most interesting part of this chart is the "what if." We know what a world of USDCNH between 7 and 7.10 looks like, but one where USDCNH breaks this trend line is a fundamentally different world and it is one that is increasingly worth entertaining.




All the best and stay safe. jonturek@gmail, @jturek18.

Can Global Fiscal Make the Great Transition

Overall: The market seems to be breaking down between two time horizons, and I think we are approaching an inflection point in terms of knowing which side it will choose. Of course, the vaccine news has been very positive and the delta change of, earliest in 18 months to now likely getting one in 2021, has been worth a lot of spoos points. However, in terms of the broader macro dynamics, the market will soon tell us which side of these two dynamics are at play. Was the market underpriced for a pickup in activity or has global fiscal changed the macro landscape going forward.

side one:

- The market was completely offside for what both data and CBs are saying, the depth of the downturn is less than originally feared. The market got a decent opening in the backdrop of positive Chinese industrial activity and immense fiscal buffers to consumption.

side two:

- Global fiscal/monetary policy is a changed beast, the only question now is staying power. Will South Korea follow through with a "new deal" post covid, will Germany actually make investments that change domestic growth composition away from just exports. There is no question that this global policy impulse has changed the distribution for "bad" economic outcomes, the question now is can policy transition from something that is filling a demand hole to being the train of renewing domestic demand.

This is what the market is fighting against. The first side, will likely run out of room in terms of driving a cyclicals rally (usd/curves/EM etc.) However, if the second side of this formulation is real, the global economy could exit covid with a much more balanced and synchronized growth dynamic and that would have immensely positive spillovers to things like EM. As always, I believe the answer will lie in USD. As the broad dollar retests certain key levels, we will get the answer if this move was just the market offside for better than expected activity levels or has something more fundamental shifted.

Sections:

- Global fiscal transition and USD

- Risks of a Chinese "W", will CBs let it run

- A few trade expressions

Can global fiscal make the transition, USD will tell us

I want to focus on two key things driving the transition from markets pricing liquidity to markets pricing reflation.

1) Chinese industrial activity has been "V" like. The proof of that has been in things like iron ore over $100, Chinese oil demand back to 11mbd, and Aussie above its 100 week moving average for the first time in over two years.

2) Europe got its act together and the EC recovery fund proposal has reduced a lot of left tail risk in EUR which in turn has weakened USD safety premia. It is no coincidence that the dollar broke its consolidation pattern downward three days after the Franco/German proposal was put in motion during a joint press conference with M&M. Between an upsize of PEPP last week and the current EC proposal, fragmentation risk in Europe is off the table. Is it perfect, is it big enough, these are valid questions but both miss the bigger point, the precedent has been set and the train has left the station.

The way these two factors have coexisted has really changed the macro landscape over the past few weeks. The key reason being, both on their own right take air out of the US dollar and together have hit it hard.

Both affect the dollar in different ways. China being able to get its industrial activity back much quicker than the market thought has been dollar bearish because in a comparative sense the dollar is much less exposed to Chinese industrial activity than the rest of the world is. Europe reducing left tail risk has been huge in changing the trend for the dollar also. EUR is a key part of the broad dollar index and given fragmentation risks it was on a steady path of being dragged lower by rising spreads and political vulnerabilities. As Europe traded with left tail risk from rising government spreads and fragmentation risk, this pushed the Euro to the weaker side and dragged a lot of currencies with it. However, as some of this left tail risk comes out, there is a rebalancing in FX and the dollar loses some safe haven premia it was previously trading with.

So the combination of these two factors have been huge in breaking the dollar consolidation lower. The question is, are both of these things enough to send it past its previous breakout level. What is the catalyst for the dollar move to turn into a more medium term sustainable trend instead of this potentially just being a retest.



Maybe its global fiscal policy finally getting its act together

One of the things that will determine the sustainability of this dollar move, past this current reflationary episode, is the global policy impulse post covid. The reality is, for this current market move of cyclicals leading, EM rallying and curves steepening etc. a lot of it is a big delta change in implied probability, not necessarily a change in the baseline. Basically, the market was completely offside for any signs of reflation. Now the market is entertaining how big global policy stimulus is in the backdrop of what the data & CBs (RBA/BoC last week) are saying, the depth of the downturn is less than originally feared. This narrative shift happened into one sided positioning, so it is very likely this cyclicals led bounce is largely being amplified by positioning.

However, it is possible for these current shifts to be part of a new broadening trend, and seeds for such a market shift are being planted.

What is very interesting to see over the past few weeks is, countries who traditionally run tight fiscal policy are starting to embrace the potential for an expansionary fiscal position even post covid.

- Japan is onto its second supplementary budget with Abe's cabinet approving over $1.1t in new measures.

- Europe is embracing the Commission playing a role in fiscal transfers as part of the Recovery Fund, effectively expanding EMU fiscal scope. Germany is onto its second fiscal package, worth 130b Euros.

- South Korea is starting to talk about a fiscal stance that lasts beyond covid, which Moon has talked about being "new deal" like.

The question for markets going forward is, does fiscal make the transition from serving as an economic cushion to an economic accelerant.

Can fiscal make the transition from supporting business' and employment to making structural economic changes in terms of growth composition and competitiveness. If countries like Germany, South Korea etc. economies that have previously been focused on their export sectors, almost at the expense of domestic demand (see prior post) that changes the macro economic landscape in a paradigm shift sort of way. And the dollar doom loop of the previous decade, where global trade slows/relative US economic outperformance, self reinforce each other, finally gets turned on its head as global growth becomes a lot more balanced and synchronized.

To me, this chart is a sign that the market is taking this shift very seriously.... 30y JGB yields back to summer 2019 levels.



The spillover of a more balanced growth level can by itself positively impact EM, even if many of those countries that still lack relative policy capacity. So yes, EM still has domestic growth challenges and no carry to attract flows, but dollar weakness can cover over a lot of those cracks.

A weaker dollar can solve a lot of the global economy's ills.

The IMF financial stability report estimated dollar impact on cross border lending to EM. We saw in 2017 how this works in reverse, it's pretty powerful.



The risk of Chinese "W", will CBs let FX run

One of the interesting dichotomies in macro right now is, Chinese activity has been a key reason for the V like feel in markets but Chinese policy has not been that expansionary, especially in a relative sense. Chinese policy making post NPC seems to be focussed on targeted measures and despite removing "flooding" from communiqué, nothing Li has said makes it seem they will revert back to flooding. Infrastructure spending is up as the Chinese authorities are at least establishing a baseline for growth while not targeting a specific level this year. The question now is, what legs does China have as a growth driver if the things that have gotten markets here are implicitly capped. Yes, the market was completely offside for Chinese industrial activity to pick up as quickly as it did, and the added juice of increased infra spending has nudged the global cyclicals trade, weaker USD, steeper curves etc. The problem is, by itself, what scope does it have.

A few things:

1) The Chinese only seem to be using infrastructure as a way to plug growth holes, not some new fiscal campaign.

2) The Chinese industrial machine is back on, at what point is it too much for the global consumer to absorb, as they will likely be backed by fewer fiscal buffers.

Without a commensurate follow through from global econ with fiscal policy that transcends just making up lost demand and takes a more decisive role in growth going forward, the Chinese industrial train doesn't have that much steam. It was easier than priced to turn the Chinese industrial machine on, it may be harder than priced to fully turn on the global consumer.
The other question is, do central banks get the joke on FX

What is also interesting, especially in light of how far many of these currencies have run is, will central banks let the system heal. The reality is, part of a reflationary world is a +75c aussie dollar, +70c kiwi, +1.15 euro etc. The joke now is that terms of trade don't really matter when there is no trade. However, will people like Adrian Orr decide to reintroduce NIRP risk to get kiwi off its highs. For now, there isn't talk of Lowe or Debelle coming in scared about how high AUD is. It will be key for this dynamic to last. It would be unfortunate if CBs decide to fall back into their old traps of falling for FX at a time when potentially some of the Chinese demand impulse that got us here is beginning to come off.

This is the potential for this weak USD trade to get circumvented. Chinese industrial demand slows at the same time export CBs start to worry about FX. It hasn't happened yet but it is worth watching for.

Some potential trades:

- One of the trades I have liked the past few months is, being long good outcomes in Spoos and bad ones in FX, via EM. That trade had worked great until a few weeks ago. With that said I think there is a similar concept at play now. One of the things I have been doing is effectively an RV trade between risk products as a way to gauge what is the nature of this rally, temporary/or regime shift. A trade I like in that regard is also an equity v FX trade where you sell NK1s against the highs to buy upside in things like KRW. The point basically is, if Nikkei makes a new high, that is very telling in what the market is saying about the global economy going forward, however in that world, USDKRW at 1200 is just the wrong price. And if this is a rally on underpriced factors and faces a coming cliff in the form of fewer fiscal buffers and less Chinese demand, NK1 could reprice a lot faster than KRW.



- To me there are three potential outcomes for the spread between 10y French OAT v 2y German Schatz.

1) reflation, spread will steepen
2) deflation but no EUR risk, flatten
3) deflation with EUR risk, steepen

This balance of probabilities is pretty suggestive of a steepener. Of course its possible the market just grinds back to 50bps as EUR risk is completely taken out of distribution. However, that seems like a worthy 10bps as the two other possibilities contain likely +50bp moves.



- Another trade that seems interesting is long EURTWD. Basically this trade encapsulates two pretty interesting domestic factors. One, USDTWD has probably run a bit too far for the CBC's liking, and if this dollar move lower were to continue, it would be fought. So off the bat being short TWD right now, you get carry from the negative points (thanks lifers) and the CBC will likely begin to lean against. The other side of it is, something has changed in EUR with this EC proposal. Is it perfect, likely not, but the precedent is a game changer. And as fragmentation is reduced as part of the distribution, that should change how this cross trades in risk off.




All the best and stay safe. @jturek18.