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.