There’s
been a lot of discussion recently about $ strength preventing risk assets from
making new highs. I don’t dispute the fact – it’s pretty obvious that we’re
losing badly in the battle for competitive devaluation that global central
banks have embarked upon. But it's even worse than the headlines might suggest.
To refer to this as a “USD bull market” is not correct. As
others have correctly pointed out: it’s a bear market for $ funders. Typically,
we’d see this manifest in overnight repo rates, but that’s not really happening.
We might also see this show up in LIBOR/OIS spreads (and cross-currency basis)
& it has, but to a fairly limited extent.
Where this is
showing up instead is in FX forwards. In times of trade war, this is currency
krav maga - the art of self-defense.
Consider
this: since the start of the year, the average 1-year funding cost in EUR, GBP,
JPY & CAD has moved by about 30%. Cheaper for those currencies, more
expensive for the dollar.
Moreover,
it’s showing no signs of stopping. It’s essentially an explosion of the developed
markets FX carry trade: borrow in currencies where interest rates are low (or,
in many cases, negative), to invest in those countries where yields are high. In
order to do that, you need dollars. In the case of each of the 4 currencies
listed above, the forward value of the dollar is cheaper than the spot – making
the trade that much more attractive. Perhaps this stops when we reach zero,
perhaps it just continues.
But that’s
not even the biggest move. Beyond the developed markets, the real jump has
taken place in just the last month as USDCNH forward points have gone up by
more than 2x.
On a trade
weighted basis, this is a monster move.
Take the
top 10 currencies on a trade weighted basis (I’ll use the Fed’s weights for the
sake of comparison).
Consider
what the trade weighted $ performance has been in spot space.
Now,
overlay what the trade weighted $ performance has been in forward space all-in
(spot + forward points).
Bottom line, it’s
pretty clear that this $ move is being driven by the forward borrowing cost
versus our major trading partners. In a trade war, this is logical self-defense.
But the extent of the move is going almost entirely unnoticed since the spot
richening of the $ has been “only” 5% over the same time period.
Until the forwards
begin to retreat in a meaningful way, it’s only reasonable to presume this move
should continue.
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