The U.S. Dollar And A Morphing Investment Climate

We have all been hopeful that a vaccine could be developed for the coronavirus, and these hopes were not vain. Pfizer (NYSE:PFE) and Moderna's (NASDAQ:MRNA) promising results are just the tip of the iceberg, and in the coming weeks, more results from other companies are expected. Make no mistake about it. There is a several-month long slog in front of us as the virus surge has yet to be convincingly turned in Europe, let alone the US, which seems to lag behind a couple of weeks. The data highlight of the week, the preliminary November PMIs will likely underscore the adverse economic impact.

There is more stimulus to come. The ECB is the obvious candidate. It has all but promised to increase and extend its emergency bond-buying program and new low-rate loans. It appears to have ruled out a rate cut (deposit rate at minus 50 bp), but a key funding rate (three-month Euribor) fell to new record lows as the Eurosystem is awash with liquidity. The EU's budget and the 750 bln euro Recovery Plan has been stymied by a contradiction. On the one hand, the decision requires unanimity, and on the other, it seeks to use it as a force a certain behavior (as admirable as it may be, the rule of law) that is clearly aimed at two of its members.

The political elites and apparently a large part of Poland and Hungary do not accept some of the premises of Brussels' liberal, progressive, secular worldview. This seems vaguely similar to the so-called culture war in the US, where the vast majority of Americans in rural counties voted for Trump in higher numbers than in 2016. The fact that presidents who lacked a majority popular vote appointed a majority to the US Supreme Court or the demonization of the traditional media strike many as parallel developments.

With the surge of COVID cases and social restrictions biting, economists have begun forecasting a contraction in the eurozone in Q4. The US economy has lost some momentum. This was driven home last week by the weakness in October retail sales. The increase was considerably less than economists had anticipated, and the September series was revised lower. Indeed, core retail sales, which exclude auto, gasoline, and building materials used in GDP calculations, nearly stagnated (0.1%).

Fiscal stimulus in the US was never particularly likely during the lame-duck session. And much rests on the outcome of two run-off elections in Georgia in early January. The Treasury Department's Office of Financial Research warned last week that the inability of many households and businesses to recover without more government assistance puts the financial system at risk.

Despite the rancor,  Congress is coming together and appears near an agreement on each of the 12 federal departments' spending. This brings them closer to passing an omnibus appropriations bill by the December 11 deadline. The details are what will be negotiated over the next three weeks. There is another element of uncertainty. President Trump opposes omnibus appropriations bills and could refuse to sign. In the past, such uncertainty around the deadline has sometimes been reflected in the short-dated T-bill market.

After the election results were clear enough for market participants, the reflation trade lifted US rates and steepened the curve (bearish steepener). The 10-year yield rose to new highs since March of almost 1.0%. However, more recently, the yield has softened. The curve flattened a bit on strengthening ideas that the Federal Reserve will shift its buying to the longer-term securities, ostensibly providing more stimulus. Without committing to it, Fed officials, including Powell, have suggested the possibility. Many recognize that the lack of additional fiscal stimulus, the weakening data, and surging COVID boosts the chances of Fed action.  

The Federal Reserve is buying $80 bln a month of Treasuries and $40 bln a month of MBS from the Agencies. The Fed could increase its purchases, but this seems unlikely primarily because it is unnecessary if it focuses its buying at the long-end. Fiscal stimulus is still the most likely scenario early next year. The vaccine news is also favorable even if not immediately helpful for the economy. Some have tried linking the possible expiration of most of the Fed's lending facilities to boosting bond purchases. Still, they are hardly fungible, work on different channels, and officials have tried to keep them distinct from monetary policy proper.

Still, a more challenging turn of events is possible. The failure of Congress to approve or the President does the appropriations bill forces the government to shut. And it comes during this horrible pandemic when the government's resources are in greater use. At the same time, President Trump continues to challenge the election results. Consider the key dates. December 8 is the deadline for resolving all election disputes at the state level. December 11, the federal government's spending authorization ends, and on December 14, the Electoral College votes. The Federal Reserve's two-day meeting concludes on December 16. A major disruption is not the most likely scenario, but at the same time, the unthinkable must now be thought about.

The prospect of a vaccine and a more robust recovery by the second half of next year has persuaded many economists or deepened their conviction that the dollar will fall next year. Stephen Roach, former Chair of Morgan Stanley Asia and the bank's chief economist, has warned that the dollar may lose more than a third of its value against the euro next year. While it is theoretically possible, it would be unprecedented. The strategists at one of the US's largest banks look for a 20% decline in the dollar next year. The euro's largest annual increase since it was launched in 1999 was in 2003 when it rose by a fifth. Europe's negative interests and the record excess liquidity (three-month Euribor, which acts as a funding benchmark, fell to record lows last week, a little further below the minus 50 bp deposit rate) seems to argue against a repeat, let alone an unprecedented euro surge.

On the other hand, the Bloomberg survey's median forecasts for the end of next year seems too mild. The current projection of the end of 2021 is $1.2150 for the euro, $1.3550 for sterling. The median projection of the dollar at JPY106 and CNY6.60, both of which are higher than the current spot. However, it does raise two issues. The first is about the volatility. Before the pandemic hit, low volatility had characterized the foreign exchange market, like many other asset classes.

There were two periods of volatility this year—one in March and one in July—and since then, the European-biased Dollar Index has mostly traded between 92.00 and 94.00. With a couple of exceptions, the euro has been chopping between $1.16 and a little more than $1.19 for nearly four months. The dollar has been JPY103-JPY107. since mid-July, and most of the time, JPY104-JPY106. For the Australian dollar, the range has been $0.7000 to $0.7400. With Brexit looming, sterling has to be given slightly wider berth, but it has spent hardly any time below $1.27 or $1.34 for nearly four months. The greenback has mostly been between CAD1.30 and CAD1.34 over the same period. We can debate the macro and micro forces that make for relatively low volatility among the major currencies, but there may be good reasons to expect it to persist.

The median forecast in the Bloomberg survey projects the yen and yuan to underperform the euro and sterling. This raises the traditional greater sensitivity to exchange rate movement relatively open (exports+imports as a percentage of GDP) Asian economies. Several are already protesting, including Thailand and South Korea. South Korea's finance minister threatened intervention and spurred a 1% sell-off of the won, giving back the week's gains on November 19. In the middle of last week, the Bank of Thailand expressed concern about the "rapid appreciation of the baht as this affected the fragile economic recovery."  The baht was approaching its best level of the year set in January, which was also the highest in seven years. The central comments sparked a bout of profit-taking.

It is not just emerging markets. Japan's prime minister and central bank governor warned of excess volatility when the dollar broke below JPY104 earlier this month. And President Trump's repeated attempts to talk the dollar down are not forgotten because there will be a new president. The US currency policy is in disrepair. Belatedly, the US cited China as a currency manipulator and reversed itself a few months later. More recently, Treasury created its own currency valuation model, and the Commerce Department has been empowered to use it to assess countervailing duties and apply it to a country (Vietnam) whose GDP per capita is 1/25 of the US and intervened to slow the dong's appreciation. Last week, without even citing its model, the Treasury Department reportedly informed Commerce that the yuan was 5% overvalued.

There are some calls that the new US administration should look to rejoin the Trans-Pacific Partnership  (now called the Comprehensive and {0|Progressive}} Agreement for Trans-Pacific Partnership). These and other attempts to simply reverse what Trump did to reverse what Obama did does not sound like a compelling way forward. Nor is the way to demonstrate US leadership to become the demandeur, the applicant, of a free-trade agreement. It can begin by hosting a G20 summit and getting its own currency policy straight.