Australian dollar booms again

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No charts today. Suffice to say that DXY keeps on falling and that’s enough to drive commodities and commodity currencies higher. How far will this get in 2021? Let’s turn to GaveKal:

On Thursday night the US dollar index broke below the 90 level and so put an exclamation mark on two months of weakness. This sell-off means that the DXY now trades on a 14-day RSI of 22.8. The dollar is thus about as “oversold” as it has been in recent years. And up until 2020, buying the US currency at “oversold” levels was a winning strategy, if only because it was in a structural bull market. However, in the past year, buying the dips (whether in mid-June, late July, or early December) has not delivered positive returns, even for shorter-term investors. So will the fourth time be the charm? I have often said that foreign exchange markets are like serial monogamists: at any moment many different factors can impact prices, yet forex markets tend to have a one-track mind and chiefly focus on just one; whether interest rate differentials, looming changes in monetary policy, trade balance differences, relative shifts in fiscal policies or structural growth rates of GDP. Today, it is not yet obvious what is driving the US dollar’s weakness, for there are many possible factors. But suffice to say that none of the important drivers seem set to roll over anytime soon.

• Differences in real rates: Real short rates in the US stand at around -2% today. Given that policy rates are unlikely to rise in the near term, inflation expectations are bouncing back and base effects imply inflation taking a leg higher in 1H21, US real rates seem set to decline to fresh generational lows. This situation is hardly supportive of the dollar.

• A worsening trade balance: The US’s deficit with the rest of the world is approaching levels seen in 2008 (see The Three Key Prices: The US Dollar). Moreover, the ongoing collapse in US shale oil production means the US trade balance will likely blow through these levels and continue to make new all-time lows for the foreseeable future. In other words, the US consumer is today exporting more dollars to the rest of the world than ever before. To make matters worse, the constant use of fiscal stimulus encourages US consumers to go further down this path.

• The deterioration in US budget deficits: Just as the growing footprint of the US government encourages US consumers to push dollars abroad, this same surge in budget deficits invites foreigners to question whether they want to keep holding the currency. After all, the US government will this year have added more debt per capita (US$12,800) then any other government at any time (see The 10 Important Changes Of The Past Year). And with government spending in 2021 likely to stay high, it seems that, by this time next year, the US may have the highest public debt per capita of any country in history. This may not matter, or it may lead foreigners to get rid of their US dollars in a hurry.

• Attracting foreign capital: One reason why surging US government debt may not matter would be foreign holders of dollars remaining convinced that US assets still offer the best path to riches; i.e US companies continuing to deliver far higher returns than rivals. Foreigners have poured capital into the US on the view that the likes of Google, Amazon and Apple, which have delivered outsized returns for a few decades, will keep doing so. Yet the US government is now openly challenging the power of tech companies; 10 states are suing Google, alleging that it has run an illegal digital-advertising monopoly and enlisted its ostensible rival Facebook, in a plot to rig ad auctions. In such an environment, will foreign investors remain convinced that US equities offer the only path to riches?

On this last point, the back-end of 2020 is starting to deliver some interesting data points. To start with, the north-Asian equity markets of China, Taiwan, Japan and South Korea are now outpacing the S&P 500 for the year, as is Sweden, while Germany is fast catching up. In short, outperformance is being seen with those “industrials” focused markets that also tend to benefit from the unfolding renminbi bull market (see The Importance Of The Renminbi).

Second, while the S&P 500, to everyone’s great joy, has continued to make new highs in the closing part of this year, once adjusted for the falling dollar, that high was made back in February. Since then, for a foreign investor, the gains in the S&P 500 do not offset US dollar exchange rate losses (see lefthand chart overleaf). Meanwhile, the MSCI World is making new highs.

Third, the reason the S&P 500 is struggling to compensate for US dollar declines is that most big US tech stocks made new highs over the summer, but have since fallen back. Google is still above its high, but Facebook, Amazon, Apple, Microsoft and Netflix are down -5% to -10%. And, this, against an MSCI World that is making new highs (see right-hand chart overleaf).

Now, this may be a short-term consolidation and foreign investors may soon rekindle their love affair with large-cap US tech stocks. And in so doing they may help put a floor below the oversold US dollar. Then again, they may instead decide that the US currency—and beyond that, the US economy—is resembling a sick emerging market on the basis of the following:

• It offers the bad combination of rising yields and a falling currency. In a healthy environment, rising yields should lead to a firmer currency. Anyone who has spent time in emerging markets knows the mix of rising yields and a falling currency usually means capital outflows are occurring. US budget deficits do not inspire confidence among foreign investors US equities may no longer promise the world’s highest returns

• There has been an inability to run a “clean election”, or at the very least, an inability to run an election seen as clean by the overwhelming majority of the US population and the political class. If this is not an “emerging market” trait, I don’t know what it is!

• The inability to get government spending under control (I am not even the oldest partner at Gavekal, yet I’m old enough to remember when US$1trn was a lot of money). Today, the US government is proposing to add U$1trn to the national debt every three months. And basically, the US is now on a path whereby every sitting US president seems intent on adding as much debt into the national ledger as all of his predecessors combined. A very apres-moi le deluge approach to domestic finances, which again, is usually more prevalent in emerging markets.

Thus, putting it all together, the US dollar may be oversold, but it does seem to have started a structural bear market. Given all of the above, it will likely take a significant event (perhaps a major non-US crisis or US tech stocks again strongly outperforming) to derail this particular train.

A few points:

  • I agree with this to an extent but the world has changed. MMT is the cyclical stimulus such that deficits do not matter as much as they once did. The new fiscal constraint in this world is not deficits per say but inflation, where central banks are still constrained by targeting.
  • As well, trade deficits will be mitigated over time by the falling DXY.
  • So, for now we are in a cyclical DXY bear market. But whether it is structural is another question entirely. And I have my doubts.

So long as China is the global growth leader then markets can bid CNY and look through pandemic weakness in developed economies, most notably in Europe. But when China slows through next year, and its housing market stalls, then the next shoe to drop is the European export monster:

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Meanwhile, the US will recover explosively through H2, 2021 and inflation will bounce.

This sets us up for a relatively short time frame in which CNY turns down again and China once again starts exporting deflation, especially via commodities, either through H2, 2021 or into 2022. Markets will begin to anticipate slowing European growth as well and EUR will come under pressure which always forces up DXY.

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As this reversion to global deflation transpires, the US will see a return to growth and yield advantage plus a resumption of the tech growth stock revolution.

In short, I see an ongoing DXY bear market, stock value-rotation and inflationary pulse for 6-12 months then a reversion to the deflationary settings that force DXY higher and AUD lower.

This is not, yet, a structural DXY bear market. If the Democrats were to win Georgia we might edge closer to such, especially if MMT became more embedded in the US. But we are not there yet.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.