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Marcuard's Market update by GaveKal Dragonomics
Our admittedly unscientific survey of clients across multiple conversations would suggest that the most popular trade of 2013 was to be underweight European equities. That did not work out. When 2014 rolled around, the most popular trade tended to be short long-dated bonds everywhere, but especially in the US. Again, the consensus was wrong-footed. In 2015, the overwhelming consensus trade has been to be long the US dollar; and for now, and contrary to the last two years, the consensus seems to be riding a winner. Indeed, in the past week, the trade-weighted US dollar has visibly broken out of its recent consolidation range and the DXY is up almost 3%.
Interestingly, this substantial breakout has occurred thanks mostly to the collapse of the euro. Indeed, the US dollar has yet to beat recent highs made against the yen (121.4 on Dec 5), the British pound (0.6663 on Jan 30), the Australian dollar (0.769 on Feb 3), the Swiss franc (1.019 on Jan 14, the day of the peg removal) or the Indian rupee (63.95 on Dec 15). Of course, the dollar’s recent strong momentum could put some of these recent currency lows under pressure in the coming days and weeks. After all, the first thing every currency trader is taught is that ‘the trend is your friend’, and right now, the trend is for a stronger US dollar. So what could break this trend?
It doesn’t seem that disappointing US economic data will do the trick given that, since the start of the year, European data has mostly surprised on the upside and US data on the downside. This observation is not withstanding last Friday’s volatile and highly adjustable US payroll number. Similarly, the dramatic underperformance of US equities in local currency since the beginning of the year has not triggered an outflow from expensive US stocks into other markets.
Two simple facts lead us to the conclusion that, right now, foreign exchange markets are driven almost entirely by interest rate differentials. Indeed, one should always remember that forex markets are fickle creatures with limited though concentrated attention spans. Sometimes, the only thing that foreign exchange markets care about is changes in trade balances (think 2004-06 for the US dollar). At other times, differences in asset price performance will be the main driver of behavior (think late 1990s in the US); on other occasions it will be differences in real interest rates (think yen 2008-12) or the differences in nominal interest rates. Clearly, recent currency price behaviour indicates that today, we stand in this latter category. This makes the next few weeks particularly interesting. Indeed, over the coming days, we will likely either see:
1) The US dollar takes out its highs against most of the currencies mentioned above. This breakout will, in turn, likely trigger portfolio re-allocations and raise questions such as: (i) how will the rising dollar affect global trade? (ii) could the rise in the US dollar start to become exponential, as it did in the early 1980s, as anyone with US dollar liabilities looks to pay back? (iii) can emerging markets continue to deliver the majority of global growth in a rising US dollar environment; and, (iv) how will the rising dollar affect US corporate earnings? In short, a break-out of the US dollar could trigger renewed volatility across a number of asset classes, not least of which are US and emerging market equities.
2) The US dollar does not break out against the above currencies and the market concludes that the main story in foreign exchange markets is no longer one of US dollar strength, but euro weakness. From there, the important question for investors may be whether eurozone equities start to outperform enough to compensate for the falling euro (in which case international investors who still underweight Europe will have to scramble to cover their underweights), or not (in which case European equities will continue to shrink as a share of most investor benchmarks).
So, as the first quarter rolls to a finish, should we ‘beware the ides of March’? It seems that the markets are setting themselves up either for a sharp rise in the dollar, which would likely trigger a renewal in volatility, or for a sustained outperformance of eurozone equities. Needless to say, we would rather see the latter. But buying a little protection through S&P 500 puts, options on volatility, or even using the recent dip in US long-dated bonds to add to long positions may well make sense.
