An important topic that has been making the headline over the past few weeks is the new surge of the US Dollar (vis-à-vis the major currencies) in the last quarter of 2016. Since its Obama Rise peak that occurred in mid-March 2015 (after a 25% appreciation), the US Dollar has been ranging against most of the major currencies (except the British pound due to political uncertainty and post-Brexit effect in June, and more recently the Mexican peso). The main reason for that long period of stagnation, in my opinion, was a shift in expectations of monetary policy in the US. After the Fed stepped out of the Bond Market (on October 28th 2014), market’s participants have been mainly focusing on the short-end of the curve, questioning themselves if the Fed was going to start a tightening monetary policy cycle. We saw a hike in December 2015 (25bps), which was immediately halted due to the market sell-off that followed afterwards (13% drawdown in US equities, 20% in Europe and Japan…). Therefore, the implied probability of a second hike in 2016 crashed, which was confirmed by the 7 FOMC meetings that followed (i.e. status quo).
Then, interest in the US Dollar started to emerge again in Q4 2016; the greenback experienced a 8%+ appreciation between October 1st and its December high of 13.65 (28th) according to the DXY index (Chart 1). There are a number of explanations to that recent surge: market was gradually pricing in a rate hike for the December meeting, political uncertainty rising in Europe or Infinite QE in Japan to protect the yield curve. All these stories make sense to explain the Dollar appreciation, therefore let’s retrace the important events that occurred in the last quarter of 2016.
Chart 1. US Dollar index in 2015-2016 (Source: Bloomberg)
- Higher inflation and a positive post-Trump effect
First of all, the rebound in oil prices relieved pressure on energy-related companies [that have been falling one by one, applying to Chapter 11 bankruptcy] and had a positive effect on expected inflation. The price of a barrel has doubled since its February’s low of $26 and is currently trading slightly below $54 (Chart 2, red line) and obviously relieved US policymakers’ inflation anxiety. The 5Y5Y inflation swap forward (Chart 2, white line) stands now at 2.42%, higher than the 1.80% recorded last June. As a consequence, US long-term yields followed the move and the 10-year Treasury yield surged from a low of 1.36% reached in July last year to 2.44% today. With the unemployment rate below 5% and a Q3 GDP growth of 3.5% (annual QoQ), it seems inflation had been the main concern of the Fed’s officials in order to start tightening [again].
Therefore, on December 14th, US policymakers decide to raise the federal funds rate by 25bps to 0.5%-0.75% [and the discount rate from 1% to 1.25%], repeating a gradual policy path plan with three potential hikes in 2017. Even though it was considered to be the most ‘priced in’ hike of any Fed meeting ever, it pushed the implied rates to the upside with the current OIS (Chart 3, purple line) trading almost 1 percent above the OIS at the September meeting (Chart 3, red line). This change in implied rates was reflected in the Dollar appreciation.
Chart 2. US inflation overlaid with Oil Prices and US 10-year yield (Source: Bloomberg)
Chart 3. Fed’s dot plot and implied rates (Source: Bloomberg)
We were not very surprised when the Fed officials announced the rate hike, however we were wondering if we would have seen such optimism if equity markets ‘followed’ the global bond sell-off after the election (Trump effect). The positive US equity market reaction to Trump’s victory also comforted US policymakers for the December’s hike; we strongly believe that the decision would have been much harder if they had to deal with a sudden equity sell-off. Instead, the SP500 reached new record highs (2,277) last months.
One explanation of this development is based on investors’ expectation of an expansionary fiscal policy that will boost economic growth and inflation in the future, which are usually positive news for equities and negative news for bonds in theory (see Four Quadrants matrix – image 1).
Image 1. The ‘Four Quadrants’ framework (Source: Gavekal Research)
2. Political uncertainty rising in Europe, the rigger of many ‘forgotten’ problems
A popular trade that was running in the last quarter of 2016 was to be long the Italian-German 10-year spread ahead of the Italian referendum that occurred on December 4th. Market was pricing a potential rejection (55% chance), leading to an increase in political uncertainty in Europe, rising spreads between periphery and core and weakening the Euro.
If we look at Chart 4, we can see that the spike in the Italian 10-year yield (Chart 4, white line) could explain the Euro weakness (hence, USD strength). While the 10-year yield increased from 1.20% to 2.20% in two months (October and November), EURUSD (Chart 4, red line, inverted) went down 7 figures and reached a new low of 1.0350 post-referendum (59.1% of voters rejected the reform bill, which was followed immediately by PM Renzi’s resignation).
Even though yields have been decreasing over the past month (the 10-year now standing at 1.73%), political uncertainty could be the trigger of the two ‘delayed’ and ‘forgotten’ issues [or Black Swans] in Europe: the weak banking system and the Sovereign debt crisis. Not only Italy (in this case) cannot survive with higher yields (the country has 2.34 trillion EUR of outstanding debt – 132.6% of GDP – which needs to be rolled with low yields), but a sell-off in equities will increase the percentage of NPLs and potentially forced their banks to bail-in their depositors. The failure of Monte Paschi di Siena’s plan to raise 5-billion euros in capital from the market was ‘solved’ by a Nationalization (the bank’s third bailout). It was announced that the government will own at least 75% of the common equity after the bank is nationalized, a rescue that will cost the Italian government (i.e. taxpayers) about 6.6bn Euros according to the ECB (4.6bn Euros are needed to meet capital requirements and 2bn Euros to compensate the retail bondholders).
Therefore, We strongly believe that we will hear other similar stories in the year to come, as Italy is not the only country facing non-performing loans (NPLs) issues that affect the banking sector. Therefore, political uncertainty in Europe will weigh on the single currency and increase investors’ interest to the US Dollar.
Chart 4. Italian 10-year yield versus EURUSD (inv.) (Source: Bloomberg)
3. The weakness in the Japanese Yen
In Japan, the BoJ introduced the ‘Yield Control’ operation in order to stabilize the steepness of the JGB yield curve, offering to buy an unlimited amount of debt at fixed yields to prevent a significant surge in rates. This is kind of a puzzle, as Japan Officials cannot afford higher yields [as many indebted developed nations], however too-low yields impact revenues of the banking system and the pension / mutual funds.
We don’t think the particular surge in USDJPY was explained by this new ‘BoJ Operation’ and We prefer to say that the Yen depreciation was a result of a Risk-on effect post-US election result in addition to the recent spike in US yields. USDJPY (Chart 5, candlesticks) trades above 117 and equities (Chart 5, red line) are above the 19,000 level for the first time since September 2015; and you can see how the increase in US yields (Chart 5, blue line) is ‘responsible’ to the Yen weakness.
The question now is to know if the late Q4 Yen weakness will persist in early 2017, with USDJPY pair attracting more and more momentum investors looking to hit the 125 resistance. We know historically that the [positive] trend on the USDJPY can halt [and reverse] very quickly if investors are suddenly skeptical about the global macro situation (Fed delaying its 2017 hike path, China liquidity issues or rising yields in peripheral European countries). On the top of that, if market starts to price in inflation in 2017, will the BoJ be able to counter a JGB tantrum and keep the 10-year JGB yield at around 0%?
One important thing about this recent Yen weakness though is that it allows the Japanese government to buy time in order to implement new reforms and increase productivity. If you remember well, Abe stated in September 2015 his 20% increase in Japan GDP in the medium term (increase from 500tr to 600tr Yen in 5 years).
Chart 5. USDJPY, Nikkei 225 and US 10-year yield (Source: Bloomberg)
4. The Chinese Yuan devaluation
Another currency that has been making the headlines is the Chinese Yuan. Over the past year, the Chinese Yuan has shed roughly 7 percent of its value against the greenback (Chart 6, USDCNY in candlesticks). At the same FX reserves (Chart 6, blue line) have been shrinking; reserves plunged by $69.1bn to $3.05tr in November (most in 10 months), bringing the reduction in the stockpile to almost USD 1tr from a record $4 trillion reach in June 2014. As Horseman Capital noted in their article on China (Is China running out of money?), if FX reserves continue to plummet and the PBoC wants to maintain control of the exchange rate, Chinese officials will face some difficult choices. One option would be to raise interest rates (the benchmark one-year lending rate stands currently at 4.35%) in order to reduce outflows and attract interest in the Yuan (high interest rate differential vs. the other countries). This would have a negative effect on the country’s growth outlook, which is already concerning the developed economies due to the high levels of corporate debt and overheated property markets. Another option would be to reduce the holding of deposits by cutting the reserve requirement rate (RRR) which stands currently at 17%. We can see in Chart 7 that the Asset-Liabilities spread (represented by Foreign Currency Assets and Deposits from Other banks) has narrowed drastically over the past year, therefore cutting the reserve rates for banks could be a temporary solution for the PBoC. The problem of the second option is that it will continue to weaken the Chinese Yuan vis-à-vis the US Dollar, which could increase political tensions between US and China.
Interestingly, an asset that has [sort-of] tracked the USDCNY move this year is the Bitcoin (Chart 6, red line) , which raised from $400 in January last year to over $1,000 today. The cryptocurrency was described as the ‘good’ instrument to circumvent capital control in China in periods of large capital outflows like today. Like gold, Bitcoin is readily available in China and can be sold for foreign currencies without problems and therefore have attracted a lot of buyers over the past year.
Chart 6. USDCNY, Bitcoin and Chinese FX reserves (Source: Bloomberg)
Chart 7. PBoC Balance Sheet (Source: Horseman Capital)
To conclude, there are several factors explaining the US Dollar strength in the last quarter of 2016, and it looks like the trend should continue in early 2017 (extreme monetary policy divergence to persist in 2017, black swan events coming from Europe, difficulties of Chinese officials to deal with the capital outflows…). However its trend cannot persist indefinitely as we know that it will eventually have negative effect on the US economy in the long term. For instance, we know that a strong dollar hurts US companies’ earnings, which is already a problem if we look at the 12-month forward earnings (Chart 8, green line). In addition, if long-term interest rates increase persistently in the future (breaking through the 3-percent level seen in the 2013 taper tantrum), the US could face a budget crisis: how is the government going to fund its budget deficit [which is expected to grow over USD 1 trillion again under Trump presidency] if China and other central banks are liquidating US Paper at record pace?
Chart 8. SP500 overlaid with 12-month forward earnings (Source: Bloomberg)