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Marcuard's Market update by GaveKal Dragonomics
By Louis Gave
Foreign exchange markets are serial monogamists. The currency exchange rate between two economies can be driven by factors such as differences in their respective interest rates, monetary policies, purchasing parity levels, return on invested capital, current account deficits, trade balances and inflation rates. But at any point in time, only one single factor is likely to be the primary driver of performance, which is why currency markets tend to trend nicely.
In the late 2000s, for example, investors seemed to focus disproportionately on the US current account deficit and this drove the US dollar down. By the early part of this decade, and with structural growth becoming more scarce, the focus shifted to structural returns on invested capital; this allowed the dollar to stop falling. The “taper tantrum” of 2013, followed by the launch of quantitative easing programs in Japan and Europe meant that the focus of foreign exchange markets shifted to differences in monetary policy; a shift which obviously favored the US dollar and brings us neatly to today’s situation.
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In recent weeks, we have seen both the Bank of Japan and the European Central Bank surprise investors with very dovish policies and statements. Yet, while a wider “monetary policy gap” between the US and developed markets should have favored the US currency, the dollar has in fact stopped rising, and on a YoY basis is almost flat (see chart). This begs the question: are foreign exchange markets in the process of finding a new central driver, and if so, which one?
The first comment must be that it is early days to make such a call with any conviction. However, the logical case can be made that the next driver of currency markets will be differences in inflation rates. The one obvious policy trend in practically every developed economy is that central banks will not get in front of the inflation curve for a long while to come.
Instead, central banks are actively seeking inflation everywhere at a time when bond yields are at record lows and labor markets are broadly picking up. For any fixed income investor, this is a scary combination: low bond yields mean that bondholders have little margin of safety, while the activism of central banks means they have no one fighting in their corner. Hence, a nervous fixed income investor today can seek out (i) yield protection or (ii) deflation protection. No one will want to deploy capital into a low yielding bond market where inflation is accelerating.
If the focus of foreign exchange markets is indeed evolving away from differences in monetary policy to differences in inflation, then Chinese bonds, despite current bearishness, start to look pretty good. Indeed, the advent of zombie companies in China and with them capital misallocation means that deflationary forces are likely to intensify. And investors in Chinese bonds still get some yield protection. Of course, investors must deal with the fact the past nine months has shown Chinese policy-makers at their worst: secretive, paranoid (kidnapping booksellers in Hong Kong) and clumsy. The rejoinder must be that in recent weeks, the “policy-stumbling” baton may have been passed to other countries. From the BoJ surprising the market with negative interest rates, to the UK flirting with Brexit, to the complete shambles of the European Union’s response/anticipation of the immigration crisis. And lastly there is the possibility of a Donald Trump presidency.
On this last point, we imagine that Xi Jinping will be hoping for a Trump win in November. After all, not only has the Republican frontrunner openly cast doubt on whether the US should defend Japan, but he also advocates for America retreating behind a great wall. Better still, Trump may even shelve the Trans-Pacific Partnership (China views the TPP as an “anti-China” trade pact). If Xi’s top policy goal really is to establish Beijing at the center of a new Asian imperial domain then what could be better than a Trump presidency and a broad retreat from Asia by the US? A Trump presidency would allow China to tell every Asian country: do you want to be with us, or with Bozo the clown over there who is openly disdainful of you and is publicly saying that he will not come to your assistance?
The latter point is not bullish the US dollar. Lastly, this brings us to another possibility; that as the US political situation gets messier, a future driver of exchange rates will be shifts in the global geopolitical situation. Such shifts are very challenging to anticipate.
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