- USD on the verge of a breakout against multiple majors
- US sovereign yields 'the key trigger' for further outperformance
- Current account deficit currencies too fare worst against dollar
By John J Hardy
The US dollar is showing signs of breaking out all over and the key trigger that could continue to sustain the move is higher US sovereign yields. A further rise in US yields could intensify the pressure on currencies of the world’s current account deficit nations, from Australia and New Zealand, to emerging markets.
US two-year yields are at a local higher near 85 basis points and the US 10-year yield has pulled back above the 175 basis point level as the US trading week gets under way after a Monday bank holiday.
The rout in bond markets is interesting after Friday’s somewhat weak US jobs report. The great USD bull market of 2013 to the end of 2015 was a story that was initiated by the anticipation of the Fed unwinding further balance sheet expansion, as kicked off during the infamous May 2013 “taper tantrum” that spelled the end of emerging market currency outperformance.
USD outperformance was further driven by the actual tapering of asset purchases until October 2014 and then peaked shortly after the Fed finally hiked rates in December of 2015.
Subsequent to that rate hike, intense market turmoil set in as risky assets finally buckled under on the Fed’s hawkishness, the stronger USD itself, and especially, the Chinese yuan devaluation.
These all forced the Fed to loudly climb down from its intention to hike rates all through early 2016. Risky assets, particularly emerging market equities, bonds and currencies, responded with a stunning rebound, fed further by negative interest rate and extreme QE policies from both the European Central Bank and Bank of Japan.
The Japanese economy has been QE-powered for longer than most. Photo: iStock
Meanwhile, the US dollar languished all year as the Fed’s forward guidance on further rate hikes lost all credibility. But now, as we head into Q4, we have a Bank of Japan that is indirectly admitting QE has failed and shifting to a yield-targeting posture, while the ECB has sent a distant early warning on a QE taper.
Indeed, the world seems to be sniffing out a new theme – the end of QE as we know it and the beginning of a brave new world of fiscal, rather than merely monetary stimulus.
With this new focus will come more Fed rate hikes than currently priced, higher US yields and a stronger US dollar. New fiscal stimulus in 2017 will feed these developments as both Clinton and Trump have promised expanded public outlays.
US core inflation is already above the Fed’s 2% target by some measures and headline and core inflation could rise quickly as year-on-year energy price comparisons will steepen dramatically in the months ahead as crude oil currently trades more than 90% higher than its early 2016 lows.
After the market for so long second guessed the Fed’s attempt at hawkishness, could we now be profoundly complacent on Fed rate hike risks?
Most negatively affected by a new rise in US yields and the US dollar will be currencies of countries with large current account deficits, and in particular, currencies that enjoyed strength this year on the “reach for yield” theme. The US dollar is the world’s money and when the world’s money is getting more expensive, those countries that need outside funding for their current accounts risk falling the most. Our top picks among these currencies are the Canadian and Australian dollars among DM currencies and the Turkish lira and South African rand among EM currencies.
Both Canada and Australia are home to enormous private debt bubbles, mostly linked to the housing market, and the ever-lower-rates fuel for these bubbles is running dry while Australia banks have even begun tightening lending standards while Vancouver, Canada has pricked the local housing bubble and scared away foreign (Chinese) real estate speculation with a 15% stamp duty.
Vancouver's market has historically been enormously inflated by foreign buying. Photo: iStock
Australia’s current account deficit is on the order ot 4% of GDP and Canada’s is near 3%. And both currencies are starting from strong levels, relative to their 12-month lows.
Not so far from its 12-month low is the Turkish lira – at least in nominal exchange rate returns. But if we consider the effects of carry as shown below, the lira is not as cheap as it appears and will likely continue to devalue versus the US dollar due to the funding pressures from a higher US dollar and political turmoil restraining foreign investment to offset the current account shortfall.
Catching back up with the trend could see USDTRY well above 3.50 within 12 months.
The South African rand, meanwhile, was one of the most oversold currencies on the rejection of EM assets from 2013-15 and rebounded profoundly due to the USD weakness and the recovery in the gold price early this year. Another recent development driving ZAR strength was an enormous mergers-and-acquisitions deal, the purchase of the brewer SABMiller by InBev.
With a current account deficit of about 4%, however, the ZAR will have a hard time ignoring the pressure from a higher USD and higher US yields, which could pressure the currency back to its trendline –perhaps toward 17 or even higher over the next 12 months.
Today we saw the news that the current finance minister Gordhan will be arrested and charged with fraud, pummeling ZAR for 3%, and threatening further weakness on the turmoil.
The graphic below, extracted from Bloomberg, shows the carry-adjusted performance (so important for currencies like TRY and ZAR that have deposit rates about 700 basis points higher than USD deposit rates) of holding a long USD position versus a basket of AUD, CAD, TRY and ZAR.
The timing of the USD strength fits perfectly with the spring 2013 taper tantrum followed by the end of strength at the beginning of 2016 when the Fed climbed down from its hawkish guidance.
The reprieve for current account sinners is likely behind us if US yields head back higher.
Carry-adjusted USD versus current account deficit basket:
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— Edited by Michael McKenna