Dollar strength spells trouble for Commodities/EMs
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- Chinese Renminbi weakness ignored by complacent markets mesmerized by QE
- Move up in rates may come in confirmation of the beginning of the end for QE, in our eyes: QE running into a dead end is the real sea-change event, narrative to shift in the months ahead
The Dollar Index is approaching the highs of January 2016 after rallying 3.5% in October. Dollar strength is due to expectations of FED’s normalisation of rates and global Dollar shortage. Dollar strength is typically tightly correlated to weakness in commodities (both energy and metals) and Emerging Markets. In the last 30 years, Emerging Markets and the Trade-Weighted Broad Dollar have never decoupled for too long, opening up two scenarios from here: perhaps the Dollar weakens on the FED refraining from rate hikes (similarly to what happened earlier on in 2016), or commodities let go and depreciate. The recoupling could happen both ways, but our sense is that Commodities/EMs underperform Dollar from here.
- Dollar shortage may drive the Dollar stronger from here. Dollar liquidity is contracting when considering both US monetary base and the amount of US government securities held in custody for foreign accounts. BCA Research estimates that the rate of contraction in this US Dollar liquidity measure is at its highest on record.
- The chances of the FED not hiking in December are slim at present. On two assumptions: (i) a base case of Clinton winning, (ii) a FED reluctant to derail markets as they price in 70% probability of an hike, (iii) recent momentum in inflation numbers
- The current narrative sees positively the sell-off in global rates for it is driven by rising break-evens and inflation expectations – for example, US real rates have indeed been stable lately even while the curve was bear steepening. In contrast, we expect rates to be higher than what inflation dynamics would suggest, so to reflect structural impediments to QE: as we argued in the past (HERE), new QE is deflationary, QE is counterproductive, QE hits capacity constraints. Thus, higher real rates in the US should ultimately lead to a carry-unwind in EMs, together with weakness in Commodities.
- Energy commodities were recently helped by Oil’s strength, amid expectations of supply cuts from OPEC and non-OPEC producers. While such expectations clash against messy politics and fluid geopolitics, oil rig count in the US started rising again, production stopped falling, inventories only marginally decreased, break-evens for frackers kept moving lower.
- Base commodities have recently been supported by speculative flows out of China (iron ore and steel) and reflation expectations gaining momentum. To us, Chinese demand is illusory, on steroids (leverage/credit driven), and expect it to fade over time.
Chinese Renminbi grinding higher, to weakest levels since 2010. Continued outflows weakened the Chinese Renminbi to critical levels (as we approach 7.80), levels where global risk-off might easily be triggered. FX reserves dropped by $500bn this year, according to Goldman Sachs, way above what official data would suggest. October data to be released soon for FX reserve and position for FX purchase may shed some light. Needless to say, a continuation or acceleration of CNH deval would bring back global deflation psychosis, commodity and equity woes.
Move in rates may confirm the beginning of the end for QE: QE policies running into a dead end is the real sea change event, in our opinion, leading to a shift in dominant narratives in the months ahead. As we argued in the past (HERE), new QE is deflationary, QE is counterproductive, QE hits capacity constraints. Recent price action on banks may testify to that. Banks have rallied on the back of long rates moving higher. Higher rates were in the desiderata of Central Banks as banks’ profitability took centre stage in being blamed for the lack of credit transmission to the real economy. If banks are unhealthy/unprofitable, they cannot lend to the real economy, the narrative goes. But, in reality, it was not so much a deliberate choice for Central Banks, but rather a no longer deferrable obligation. As we kept arguing this year, not only banks were unable to lend but they were outright imploding. At negative rates and flat yield curves, banks are travelling to zero valuations, recap after recap, while still staying technically solvent. So in a nutshell, with banks trading at Price on Tangible Book Value below 0.40 (case in point Deutsche Bank), the QE option is taken away from Central Bankers, as opposed to be deliberately given up by them: it is QE hitting a dead end. Again then, QE as we know it is over, his unwind/tapering has already began – de facto in Europe, in Japan also formally so. Markets are eventually due to take notice of that, after whatever time lag they decide to accept.
Fasanara Capital – Chartbook:
Dollar Index is breaking higher
DXY appreciated more than 3.5% in October and it is now heading towards a major resistance at 100.
US Trade-Weighted Broad Dollar vs Emerging Markets Equity
The USD and EM equities have decoupled in the last few months: in the last 30 years, they have never decoupled for too long.
US Dollar Index vs. Base Metals & Oil
The decoupling between DXY and commodities is visible both vs. base metals and oil
USD/CNH at highest levels since 2010
CNH is slowly reaching a major level at 6.80 vs USD. A break above that may provide the trigger for a risk-off move, globally.
USD/CNH vs. Chinese FX Reserves
China FX reserves could be 20% lower when compared to the level of USD/CNH
Focus on FX Reserves (next release out on the 7th November), but also on ‘position for FX purchase’ (released around mid-month). Pace of outflows properly reflected by official data?
China Debt Super-Cycle in Extra Time
Just a reminder. China’s Credit-to-GDP gap stood at 30% in Q1 2016, the highest since 1995. Readings above 10% signal elevated risks of banking strains, according to the BIS. Curious to see Q2 and Q3. Bank recaps would most likely require a markedly weaker CNH.
EUR/USD vs. USD/JPY (inverted)
Are they pricing different paths for monetary policies going forward?
Perhaps, tapering seems clearer an outcome in Japan, less so in Europe, at present, slowing down JPY weakening. Hardly sustainable disconnect over time, as Japan has way more policy space than gridlocked Europe in the foreseeable future.
MSCI World Index vs. Global Economic Surprise Index
From August onwards, there has been an ever bigger disconnect between global equities and fundamentals.
No question QE supports valuations at levels way above fundamentals, but is it not too late for the QE trade today, as QE is entering its final stage?
EU BANKS vs. 10yr BUND’s yield
European banks’ equities moved higher on the back of what consensus expects to be a ‘generational low’ in rates.
Together with capacity constraints and side-effects compounding, penny-stock imploding Banks took the QE weapon away from policymakers: not a deliberate choice.
CEO & CIO of Fasanara Capital ltd.
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Registered with the U.S. Securities and Exchange Commission (“SEC”) as a registered investment adviser