One King Dollar to rule them all

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Macro Afternoon

TSLombard with the note.

Indicators of market funding stress jumped in response to Russia’s invasion of Ukraine in late February. But they soon retraced back to more normal levels, underscoring the view that central banks have learned from past crises and are prepared to step in without delay to address dislocations in market liquidity. Metrics of perceived risk in the interbank lending market, such as Libor/OIS and FRA/OIS (forward vs overnight indexed swap rate) spreads seem to suggest little cause for concern at this stage (charts 2 & 3). Libor has moved higher with the OIS curve, although its widening spread versus SOFR (which measures the cost of borrowing cash overnight collateralized by Treasury securities) could be interpreted as a sign of growing scarcity in safe collateral – something that is effectively keeping a lid on secured rates (chart 3). Further, the EUR/USD cross currency basis (i.e., the premium embedded in FX swaps) has reverted to pre-Ukraine levels (chart 4). Perhaps the more important development over the last year or so has been broad-based strength in the dollar, which bottomed out in 2021 Q2 and has trended higher since. The pace of appreciation accelerated during spring 2022 in tandem with a hawkish recalibration of market expectations for Fed policy. Following May’s FOMC meeting, these expectations have cooled somewhat and shortterm Treasury yields have rolled over, pulling USD lower (chart 1). Yet this still leaves the dollar exchange rate versus the major DM currencies close to its Covid high set in March 2020.

The Japanese yen stands out, down around 13% since March and a fifth weaker versus the dollar since January 2021. Pronounced JPY weakness – the mirror image of the rapid advance in US Treasury yields – arguably acted as a catalyst for the PBoC’s decision to let CNY slide against a backdrop of decelerating Chinese economic activity (chart 5).

Simultaneous USD strength and CNY weakness spells bad news for the world economy. A strong dollar acts a destabilising force via a number of channels that end up weighing on global trade, squeezing cross-border lending and amplifying balance sheet currency mismatch risks (for more detail on this, see our recent Macro Picture). All this as the Fed pushes through with QT, reducing global dollar liquidity and thereby rendering the refinancing of global dollar-denominated debt more difficult. What is more, a depreciating CNY puts more pressure on EM economies’ trade competitiveness and translates to diminishing support for industrial metal prices: it is no coincidence that the recent pullback has gone hand in hand with a weaker CNY (chart 6).

RMB has further to fall

Omicron has reversed the economic paradigm that drove RMB outperformance. China growth is slumping under the dual pressure of Covid-related restrictions and property-sector weakness. Meanwhile, the Fed is struggling to rein in a hot US economy. With its focus on domestic growth we expect the PBoC to maintain a strong easing bias and a preference for a weaker RMB. To put a floor on economic activity; Beijing must lower the price and increase the quantity of money. A weaker exchange rate is a welcome by-product of monetary policy focused on growth. We think a strong dollar, growth and rate differentials, and a weaker trade surplus will push RMB back to preCovid levels of 7-7.2 within the next six months. Beijing is likely to attempt a managed step depreciation of USD/CNY, with the pace of RMB depreciation a constraint on monetary policy.

The PBoC has powerful intervention tools, including commercial banks large US$ reserves, however, its ability to slow the yuan’s decline is hostage to DXY and China activity eventually stabilizing. If forced, the PBoC will prioritize growth over exchange rate management.

Euro takes a breather

In the short-term EUR/USD weakness is taking a breather, as Europe enters its post-Covid “revenge summer”; positive economic surprises support the currency directly, but they also allow the ECB to turn more hawkish against record breaking inflation. Medium term, however, the EU economy still faces the stagflation trifecta we outlined in April and with inflation that is mainly supply driven, the ECB is fighting a losing a battle. Raising interest rates further compresses already deteriorating demand and has little impact on inflation, while a neutral rate that is lower than the US and likely lower than the ECB estimates means rate hikes start to bite sooner. Europe will start to feel the pain acutely as we head into the winter; we expect EA real GDP to contract in 4Q. A widening growth and inflation differential to DM – but especially the US – will weigh on the euro. This will only be compounded by a corresponding further divergence in policy rates: slowing growth means that as we head into 2023 means there should be much less pressure to act forcefully in order to bring rates closer to neutral.

Dollar rally just pausing

More broadly, our strategists think that the dollar rally is just pausing. In the medium term, it looks like we are in an environment where we move to the right-hand side of the dollar smile (Chart 8), as US growth outperforms that of its major DXY counterparts and policy rates diverge (Japan, Europe and the UK). But, what if the market worries about a US recession are well founded? The market is pricing the Fed put – and there certainly is one, but the strike is much lower than in previous cycles. Our view is that the US would have to be staring a recession in the eyes for the Fed to stop or reverse tightening (i.e. the dollar smile is now lopsided, as the Fed’s elasticity to growth has decreased).

And risks of a US recession have risen. But in this scenario it is unlikely RoW growth would be any more buoyant, especially given our base case of a Eurasian recession. Risk assets would suffer, and we would move to the left-hand side of the dollar smile as dollar demand increased on its safe haven status. We thus currently still like being positioned long USD, especially vs high beta currencies with exposure to China.

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