Le point US de ce début d’été
President Trump appears to want much lower rates and a weaker dollar. Those views are political. If we were to get them, then US inflation risk premiums could rise. However, there are good reasons why the dollar is strong. Intervention in the currency markets has historically had mixed results and may be ill-advised considering the US economy is doing quite well. A race to the bottom currency war may disrupt financial markets, backfire on risk premiums and create even more uncertainty for business and consumers. Moreover, intervention is not guaranteed to work. It often means losses for Treasuries and central banks.
Not so volatile
Realised volatility in rates, foreign exchange, credit, and equity markets continues to be at the low end of historical ranges. The pattern in recent years has been for any spikes in volatility to be short-lived. The constant presence of the “central bank put” has always dragged volatility back down whenever there has been an increase and, as such, has fostered a buy-on-dip mentality amongst investors. This has been a key contributor to performance when deriving alpha from taking directional positions on and within markets has been difficult. The belief amongst many investors is that monetary policy and the willingness of authorities to cut interest rates and supply liquidity will continue to trump (pardon the pun) any concerns about such eco-political topics as Brexit, the US-China trade spat, and the sustainability of Italian debt ratings. The memories and policy-ramifications of the 2008-2009 period are strong enough still to influence the mass behavioural characteristics of the financial markets. Policy makers don’t want another great financial crisis, investors know that. Together with the fact that there is a lot of cash sitting on the side-lines suggests something seriously bad would have to happen if markets are to move sustainably lower.
Could FX volatility pick-up?
Against this backdrop it is interesting to think about the foreign exchange market. There has been some commentary about a potential shift in policy from the United States towards the dollar with some even suggesting that the US could intervene to try to weaken the greenback. It is true that President Trump has suggested that other countries are “taking advantage of the United States” by having weak currencies against the dollar. When President Draghi hinted that the European Central Bank could ease policy again at the Sintra meeting, President Trump framed that in the context of currency being used as a policy tool and he bemoaned the fact that the Federal Reserve (Fed) wasn’t cutting rates and, by extension, was not willing to match any foreign currency weakness with a weaker dollar. This suggests that foreign exchange volatility might be a little under-priced.
The dollar has been strong for some time. The divergence of policy rates between the US and the rest of the world began in 2015. However, bond yields had started to diverge in 2012 as the ECB had to introduce its “do anything” policy long after the Fed had already started its own quantitative easing policy. The dollar strengthened during 2012 and then again in 2014. As the global cycle started to look a bit more positively synchronised in 2017, the dollar weakened, especially against the Euro but also against Sterling which experienced a post-referendum rally. However, this soon gave way to renewed dollar strength as Fed tightening really started to make a material difference to relative interest rate levels. Interest rate differentials are not the only influence on bilateral exchange rates but over meaningful periods they are important – largely because they reflect divergences in macro-economic conditions. The US economy has outgrown everywhere else in recent years and in 2018 it benefitted from a fiscal boost that pushed bond yields even higher. The dollar rallied hard against the Euro and Sterling as a result.
China and FX
There are clearly some in the Administration who think the dollar is too strong and that this is a problem for the US economy. This may be linked to broader international trade policy and the focus on China, as the dollar-yuan relationship has mirrored the broader dollar trends. The yuan rallied against the US dollar in 2017 but last year it gave up around 10% on a bilateral basis. There is a sense that the US thinks China deliberately keeps its currency weak to gain a competitive advantage and there have been accusations that Beijing has weakened the yuan to offset the impact of US tariffs. The reality is that the yuan trades at a much stronger level versus the dollar than it did for much of the last 25 years. The weakness in the Chinese currency – if normal analysis can be applied – has coincided with a slowdown in Chinese growth, a sharp reduction in the Chinese trade surplus, and an acceleration of US growth. No surprise there. However, this ignores the political angle and the perceived persistence of an advantageous Chinese trade position vis-à-vis the US will be a driver of US policy for some time.
Is intervention possible?
Investors don’t know how seriously to take the messaging from Washington. At face value it appears that the White House would like the Fed to cut rates (it is going to do so) and the dollar to be weaker. If the dollar does not weaken on its own, then there is a risk that the US could intervene. Those readers old enough to remember when foreign exchange market official intervention was a more common occurrence will be sceptical about the ability of the US to unilaterally devalue its own currency. First it needs to decide which other currencies to buy and, for political and technical reasons, this is not likely to be the Chinese yuan. Secondly, it needs to be able to sell enough US dollars to make a difference. Exchange rate policy in the US is in the domain of the US Treasury and the vehicle for implementing exchange market intervention is the Exchange Stabilisation Fund. This currently has around $95bn in assets. These assets are split between International Monetary Fund Special Drawing Rights, US Treasury securities, and foreign currencies, mostly Euro and Yen. The dollar component is around $25bn. It could sell all that and buy foreign currency. It could swap its existing holdings of foreign exchange with the Fed for dollars and sell those dollars. It could agree with the Fed on a credit line to sell more dollars. Each of those options are increasingly unlikely and it is not clear that the Fed would agree to printing money to sell the US dollar, especially at a time when its independence is already under attack. For me this means that US intervention to devalue the dollar is both unlikely and, if it did happen, unlikely to be that effective.
Always a loser
There would be consequences of un-coordinated foreign exchange market intervention. If it leads to a beggar-thy neighbour currency war the risk is that uncertainty rises, and risk premiums go up. Inflation could rise, or at least expected inflation could. Owning break-evens would thus be a sensible thing to do if we do get into a FX intervention frenzy. It is also a zero-sum game. Someone will lose, and history suggests it is the central banks or Treasuries that think they can bully the market into accepting “desired” levels for currencies that come out the worst.
Sterling weakness still to come on “no-deal”
The EUR/USD exchange rate today is not that much different to where it was when the Fed first raised rates in December 2015. Thus, if the Fed cuts rates it is no guarantee that the dollar will weaken, especially as the ECB is likely to ease. We can’t rule out monetary easing in Japan or the UK either. So, I am not convinced about selling the dollar. There is more risk that sterling weakens further as we enter a new political era in the UK. A lot is likely to be said (if not done) between Boris Johnson being “crowned” the new leader of the Conservative Party (and therefore Prime Minister) and the supposed deadline for Brexit at the end of October. Both Johnson and his rival for the role, Jeremy Hunt, have flirted with the idea of a no-deal Brexit. Warnings against this policy from a range of sources have intensified in the last couple of weeks. Importantly, the market believes that a “no-deal” is bad for the UK economy and if the chances of that happening suddenly increase, we could see sterling plumb new lows. Sub-1.20 against the dollar and above 0.95 against the Euro are possible. Or at least volatility could increase.
Sensible economic and monetary policies don’t necessarily go hand in hand with populism (see the recent sacking of the Turkish central bank head). In a world of more extreme policy agendas, a resort to manipulating currencies could be seen. No-one wants a strong currency now and the costs of devaluation are not really recognised in a low inflationary world. But attempting to override markets in setting the international price of currency is a difficult policy, especially if done unilaterally. There is little chance of a G7 co-ordinated policy of currency intervention currently so if the US were to act alone it would surely backfire and create a risk premium in US dollar assets that could persist for a long-time. I think it is unlikely that we will see such a policy action, but in these times, one never knows. Exchange rates are difficult to predict at the best of times. Where there is political uncertainty it is even more difficult. That is why a policy of hedging exchange rate risk remains the most sensible one for international bond portfolios.
Super Over and Out
I was lucky enough to be at Lord’s last Sunday to see England clinch the Cricket World Cup. I went with my son who has become a cricket fanatic (must be a response to having spent his first year at University in Los Angeles). What a day. The cricket was amazing, and the atmosphere was something else. Britain at its best. A multi-cultural crowd thoroughly enjoyed it and made it even more of a spectacle. It was tough on the New Zealanders, but the England team were fantastic, and I was very happy for the two Yorkshire lads in the team. Indeed, the team was a melting pot as well, a fact that has been well documented. It all seemed a long way from the little Englander Brexit debate that is still going on. It was great to celebrate England’s win, even better to celebrate the fact that the best of Britain is a multi-cultural, international, open, and friendly country which can put on very special events. Long may that last.
Have a great weekend. I’m off for a couple of weeks so enjoy your summer holidays,
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