For no obvious reason, the US Dollar turned higher on Tuesday last week and barely looked back. As suspected, with a stronger Dollar came weaker equities along with commodities and high yield bonds. In short, a classic risk off week.
When we say there was no obvious reason for the Dollar’s recovery, we had actually been looking for this to happen for a couple of weeks or so, and so it was not a huge surprise. There really has been no fundamental improvement in any of the big macro concerns that have been plaguing markets for what seems like years now. The decline in the Dollar since January was in conjunction with yet another centrally ordained risk rally driven by more easy money. Unsupported by improving fundamentals, we believe these risk-on rallies are doomed to failure; it’s simply a question of trying to spot the turning points, and we continue to believe that the Dollar’s performance is key in this regard.
Furthermore, shorter term traders had definitely shifted to quite aggressive short positions in the Dollar especially against commodity currencies, and the anecdotal evidence suggests that some investors had increased exposure to emerging markets FX as well. The initial stages of a rally in any asset will be when shorts get squeezed as price rallies, and the Dollar certainly rallied after an attempt early in the week to break below significant support levels. We have shown this in chart 1 below, suggesting that the pattern seen last week in the Dollar is a solid reversal pattern, i.e. one that we believe has an excellent chance of holding true.
Chart 1 – Weekly candlestick chart of the US Dollar Index
What we think is impressive is that the Dollar closed very near the high of the week, and was easily able to shrug off some temporary weakness immediately after a slightly softer than expected US employment report. Any asset that can rally in the face of any type of disappointing news (although the US employment report was not that bad at all) is an asset that is in demand. Please click HERE to watch a 3 minute interview Stewart did with Bloomberg on Friday morning discussing the jobs numbers and the potential for a rate rise in June.
Of course, the Dollar index shown above is a broad index, and the Dollar was strongest against commodity and emerging market currencies. However, it was able to register minor gains against the Euro and Yen despite the general risk off environment – another sign that the Dollar is turning higher. We think that this performance sets the tone to the period ahead and we will be looking to focus our attention on being long the Dollar against the commodity and EM currencies. Of course, nothing moves in a straight line, and so we would prefer to buy the Dollar on any pullbacks, but if the big trend in the Dollar has turned higher, we do want to be involved, especially in the recently launched RMG FX Strategy UCITS fund – See details HERE.
We also noted a potential reversal pattern in US bonds at the end of last week. Although we don’t think the reversal in bonds is as strong a signal as the one in the Dollar, it is clearly an early warning that US bond prices may be headed lower (yields higher).
Chart 2 – The continuous futures contract on 10 year US Bond
We have been on record quite a few times in recent quarters arguing that US recession risks are a lot higher than many believe. We think that the risk in the next few quarters is for a strong whiff of stagflation as growth remains at stall speed and inflation picks up. Any decline in bond prices is likely a reflection of this stagflationary potential. As we made clear in our earlier recession risks commentaries, a recession is likely to occur after equities have entered a bear market, which we have not seen yet!
We came across the chart below illustrating what should happen to inflation in selected countries, assuming oil stays at US$45 a barrel. As can be seen, we are a month or so away from the next low in inflation, before a decent pick up into year end.
Chart 3 – Potential CPI assuming oil remains at $45
Very shortly, the Fed will have little choice but to admit that they have met their primary objectives on employment and growth. Assuming no new global worries or financial events, they will have a huge amount of explaining to do as to why they are not raising rates. It is this outcome that gives the fundamental support to a strong US Dollar.
Will the Fed actually raise rates? We are not so sure they will, but if they do, we think they will regret it later. If they don’t, they will continue to see their credibility being publicly questioned. As we outlined with Japan last week (SEE HERE), it is possible that the Fed will be damned if they do and damned if they don’t. If they do raise rates, the strength in the Dollar will hurt the economy and if they don’t raise rates, they lose credibility and financial markets decline anyway
This brings us onto the equity markets, where it’s been a pretty rough week for some. Emerging markets fell by 4.1%, Europe by 2.9%, Japan by 3.4% and the US by 0.4%. It feels very similar to recent periods where declines are being led by emerging markets and the US holds up for longer. Of course, last August and again at the start of the year, the US eventually played catch up on the downside. Frankly, we think that global equity markets are vulnerable to another sell off at some point in the not too distant future.
Chart 4 – MSCI World Index appears vulnerable to another sharp correction
It’s early days in terms of the next leg in the US Dollar’s big bull market, but it would appear that the correction is now over. A strong Dollar will be a negative for both the global economy and global financial markets. As has been the case in recent quarters, emerging markets are leading the way, both equities and currencies. European and Japanese equities continue to be moribund at best, despite negative interest rates and QE, and the US continues to outperform despite stratospheric valuations. If sentiment deteriorates far enough, then we expect all risk assets to drop sharply, as has happened twice in the last 9 months. It’s time to prepare for more volatility.
Stewart Richardson
Chief Investment Officer
