Currencies

Your feedback is important to us. Please take our client survey today. Highlights The dollar remains at risk of a countertrend bounce in the near term. The DXY could rise to 94-96 before working off oversold conditions. Nonetheless, the long-term outlook for the greenback remains bearish. The Scandinavian currencies are best positioned for outperformance over the next 12 months. Stay short USD/JPY as a core holding for now. Remain long silver relative to gold. Sterling volatility will remain elevated in the near term, but short EUR/GBP positions should provide handsome gains over the longer term. Feature The US election is just a week away. The market consensus is that a “blue wave” will usher in significant fiscal stimulus which will boost stock prices, buffet bond yields and drive down the dollar. The rationale behind these anticipated market moves is that the Democrats have been more aggressive in their demand for bigger government. Fiscal spending will widen the US twin deficits as aggregate demand rises. In anticipation of higher inflation, foreign bond investors are likely to continue fleeing the US market, driving down the dollar in the process. Fiscal spending will widen the US twin deficits as aggregate demand rises. We sympathize with this view, but it is unlikely to pan out smoothly. More specifically, a number of indicators suggest that the dollar is at risk of a countertrend bounce. This could lead to an air pocket for dollar-short positions in the near term. Our bet is that the DXY could rise to 94-96 before working off oversold conditions. The Case For A Countertrend Bounce A number of indicators suggest that conditions may be ripe for a countertrend bounce in the dollar. The velocity of money (V) is collapsing around the world (Chart I-1A and Chart I-1B). At a minimum, this suggests that realized inflation is bound to remain tame in the very near term. The dollar is a countercyclical currency, and tends to do well when global inflation is decelerating. In the case of the US, a temporary dip in inflation expectations will boost real rates, and encourage flows back into US fixed-income assets. In a general sense, V can be viewed as the interest rate required by the underlying economy (the neutral rate), since it is measured using economic variables. Once economic agents start to increase the turnover of money in the system as activity improves, it is an endogenous sign that the economy has escaped a liquidity trap and can handle higher rates. Chart I-1ADownside Risks To US Inflation Chart I-1BDownside Risks To Euro Area Inflation ​​​​The balance sheet impulse of the Federal Reserve could peak soon, relative to a few other countries (Chart I-2). This will especially be the case if other G10 countries step up the pace of their quantitative easing. This is already occurring in Canada and could soon happen in Australia. Remarkably, long-term US interest rates have started rising faster compared to its G10 peers. This was bound to happen as we stepped into a world of competitive devaluations. For most of the post-2008 period, the EUR/USD exchange rate oscillated with the relative balance sheet impulse between the Fed and the European Central Bank. The story in Japan was similar after the Fukushima crisis in 2011 and the subsequent adoption of Abenomics. In short, central bank QE becomes an important driver at the lower bound, since it is the key signaling mechanism on the future path of interest rates. Chart I-2The Dollar And Balance Sheet Impulse Currencies are about relative growth trends. Remarkably, relative growth tends to play a crucial role in currency dynamics even over the short term. For example, the upside growth surprise between the euro area and the US has started to reverse after a sharp V-shaped recovery (Chart I-3). Correspondingly, the euro has been consolidating its gains since August. On a broader scale, the OECD leading economic indicator for the US has picked up relative to its G10 peers (Chart I-4). Chart I-3EUR/USD And Relative Growth Chart I-4The Dollar And Relative Growth The exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate (Chart I-5). The AUD/JPY cross has consistently bottomed at the key support zone of 72-74. This defensive line notably held during the European debt crisis, China’s industrial recession, and the global trade war. This Maginot Line was clearly breached during the March drawdown, but we have since re-entered the safe zone. In recent trading sessions, however, AUD/JPY has been edging lower and could soon punch below the 74 level. Inflows into US equities are rising sharply (Chart I-6). Currencies tend to move in sync with the relative performance of their equity bourses. Correspondingly, non-US equity markets have relapsed relative to the US. Similarly, cyclical stocks have been underperforming defensive ones of late. The dollar tends to weaken when non-US equity markets, with a much higher concentration of cyclical stocks in their bourses, are outperforming. This is usually a clear sign that the marginal dollar is rotating outside of the US. Speculators are very short the dollar. Whenever the percentage of leveraged funds and overall speculators that are short the dollar is at or below 20%, a meaningful rally ensues (Chart I-7). Chart I-5AUD/JPY: Watch The 72-24 Zone Chart I-6Strong Inflows Into US Equities Chart I-7Many Dollar Bears In a nutshell, the market has been ignoring clear bullish signals for the dollar such as the drop in money velocity and the relapse of global interest rates relative to the US. Meanwhile, the consensus is overwhelmingly bearish on the dollar, which could make any bounce or advance go much further than most expect. The catalyst in the near term could be a market reset, given uncertainty around the US presidential elections, the resurgence in COVID-19 cases and Brexit. Meanwhile, unless animal spirits are rekindled by an invisible hand, perhaps in the form of a vaccine, then the outperformance of cyclical stocks, which is needed to boost the aggregate market index higher, is not a sure bet. Similarly, the outperformance of non-US stocks, specifically those in Europe and Japan, is also needed to confirm the dollar bear market remains intact. Positive Catalysts Chart I-8Lumber Versus Copper Despite our concerns of a near-term bounce in the dollar, there are still many signs that it will not be a durable one. Therefore, investors should use any dollar rally to establish fresh short positions. Lumber has started to underperform Dr. Copper. Lumber benefits greatly from a pickup in housing activity in the US and is very closely correlated to US domestic variables, while copper is strongly linked to Chinese and global industrial cycles. The dollar also tends to underperform higher-beta currencies when lumber is underperforming copper, as is the case now (Chart I-8). Similarly, the copper-to-gold ratio has bottomed and is heading higher from deeply oversold levels. Together with the stabilization in government bond yields, it signifies that the liquidity-to-growth transmission mechanism might be working. This is usually dollar bearish, as rising global growth leads to capital outflows from the US (Chart I-9). The gold/silver ratio (GSR) has rolled over following the recent bounce (Chart I-10). The GSR provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. Therefore, the GSR usually peaks as we exit a recession. The bond-to-gold ratio, as measured by the ratio of the US bond ETF (TLT)-to-gold ETF (GLD) remains below the key technical level of 0.90, which is bearish for the dollar (Chart I-11). The ratio measures the shift in confidence between the dollar and alternatives to the fiat reserve currency. The upside for the 10-year Treasury is much more capped than the upside is for gold, suggesting that this confidence measure will remain dollar bearish for the near future. Finally, currency volatility is high, suggesting that currency traders are no longer complacent. Usually, high volatility signals a more balanced and healthy market rotation. Over the last three episodes where volatility rose from these oversold levels, the dollar has benefitted (Chart I-12). Should volatility drop from current levels, especially in early 2021, pro-cyclical currencies will benefit. Chart I-9The Copper/Gold Ratio Leads The Dollar Chart I-10The Gold/Silver Ratio Has Relapsed Chart I-11Watch The Bond-To-Gold Ratio Chart I-12Currency Volatility Is Rolling Over In summary, many cyclical drivers still point to a lower ultimate resting spot for the dollar. Nonetheless, the character of any equity shakeout over the coming weeks will be worth monitoring. If cyclical and value stocks that are already at historically bombed-out levels start to outperform, it will signal an equity market leadership change – something that is required for the dollar bear market to resume. Investment Implications Chart I-13Sell EUR/GBP Chart I-14Place Stops On Short GSR At 80 The investment implications are straightforward. Maintain a basket of the cheapest currencies, together with some safe-havens. Also, focus on trades at the crosses. Specifically: Stay long the Japanese yen, which sports an attractive real rate relative to the US. Focus on relative value at the crosses rather than outright dollar bets. We are short the NZD/CAD and EUR/GBP as a play on relative fundamentals. We also went short CAD/NOK a fortnight ago. EUR/GBP is at risk of a significant selloff if we get a Brexit deal (Chart I-13). We already have limit orders on a few currencies, including a Nordic currency basket, AUD/NZD and EUR/CHF. We are long petrocurrencies versus the euro, and will use any tactical bounce in the dollar to shift to USD shorts. Remain short gold/long silver with a target of 50, but tighten the stop loss to 80 (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The preliminary Michigan consumer sentiment index climbed up from 80.4 to 81.2 in October. Retail sales increased by 1.9% month-on-month in September. This was a significant beat, relative to expectations of a 0.8% rise. Housing starts increased by 1.9% month-on-month in September. Building permits also increased by 5.2% month-on-month, overtaking pre-pandemic levels. Initial jobless claims increased by 787K for the week ending on October 16th. Claims have consistently come under 1000K since August 28. The DXY index fell by 0.8% this week. It remains evident from incoming data that the US economy is holding up well, relative to its trading partners. Bond yields have also moved in favor of the US dollar. While this could catalyze a countertrend bounce in the DXY, our bias is that it is not likely to be a durable one.   Report Links: Does The US Save Too Much Or Too Little? - October 16, 2020 Tail Risks In FX Markets - October 2, 2020 The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The seasonally adjusted trade surplus increased from €19.3 billion to €21.9 billion in August. This lifted the current account balance from €16.95 billion to €19.94 billion. Both headline and core inflation remained unchanged at -0.3% and 0.2% year-on-year, respectively, in September. Consumer confidence has been rolling over, but much better than you would expect given the resurgence in COVID-19 cases in Europe. The euro increased by 0.7% against the US dollar this week. The critical barometer for the euro outlook is the economic impact from the second wave of the pandemic. During an interview this week, ECB president Christine Lagarde said that the recovery could be “running out of steam.” Economic surprise indices in Europe are also rolling over, relative to the US. This sets the euro up for some indigestion before the bull market resumes. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been mixed: The adjusted trade surplus significantly widened from ¥248 billion to ¥675 billion in September. Exports fell by 4.9% year-on-year in September, up from a 14.8% decrease the previous month. Imports continued to fall by 17.2% year-on-year. The Japanese yen appreciated by 0.7% against the US dollar this week. Sluggish imports reflect weakness in Japanese domestic demand, which is putting upward pressure on real rates. Meanwhile, Suga-san’s push to continue pressuring telecoms to drop prices does not bode well for the BoJ’s inflation target. As such, the yen remains a very attractive currency when real rates are compared across the G10. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been robust: Rightmove house prices surged by 5.5% year-on-year in October. Headline inflation increased from 0.2% to 0.5% year-on-year in September. Core inflation also ticked up from 0.9% to 1.3% year-on-year. CBI trends continue to improve in terms of both orders, selling prices and business optimism. The British pound increased by 0.7% against the US dollar this week. Sterling action will continue to be dictated by the evolution of Brexit. The UK public sector has no choice but to step in as a spender of last resort amid the twin economic and health crises. In fact, net borrowing surged to £35 billion from £29 billion in September, which was more elevated than expected. Rising public debt has pushed Moody’s to downgrade the UK’s sovereign credit rating, warning that Britain “effectively has no fiscal anchor.” That said, positive action on the pound this week reflects the market’s laser focus on the terms of the UK’s withdrawal from the EU, and nothing else. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been soft: The Westpac Leading Index declined from 0.49 to 0.22 in September.  Retail sales declined by 1.5% month-on-month in September. The Australian dollar appreciated by 0.4% against the US dollar this week. The RBA meeting minutes released this week implied further easing from the central bank, which might include further rate cuts and some expansion in its QE program. Interestingly, softness in the AUD, particularly against the NZD is setting the stage for a nice entry point. AUD/NZD slipped by 0.7% on the dovish RBA minutes. Over the longer-term, our fundamentally bullish bias on the AUD is based on strong relative terms of trade, and a currency that remains undervalued. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There has been scant data from New Zealand this week: NZIER business confidence fell by 40% quarter-on-quarter in Q3. Credit card spending fell by 9.9% year-on-year in September, but is a marked improvement from the 48.6% drop earlier this year. The New Zealand dollar surged by 1% against the US dollar this week. Prime minister Jacina Ardern’s election sweep over the weekend has boosted confidence on a more fluid government in New Zealand. That said, our updated PPP models shows that the New Zealand dollar is currently close to its fair value, while other major DM currencies, with the exception of the US dollar, are significantly undervalued. While NZD could rise against the US dollar in the near term, it should underperform at the crosses. We are short on NZD/CAD in our portfolio and it’s 2.5% in the money. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been positive: Headline inflation jumped from 0.1% to 0.5% year-on-year in September. Most measures of core inflation have held steady, but still came in below the midpoint of the BoC’s 1-3% band. The core median CPI came in at 1.9%, similar to last month, in line with expectations. Retail sales continued to increase by 0.4% month-on-month in September, but came in below the expected 1.1% rise. Teranet/National Bank House Prices increased by 6.7% year-on-year in September. The Canadian dollar appreciated by 0.3% against the US dollar this week. The most important release for Canada this week was the Business Outlook Survey, which showed a notable improvement in Quebec, Alberta, and the other Prairies. The pickup in September’s inflation figures also lowered the possibility of further rate cuts when the BoC meets next week. We remain positive on the CAD, expecting it to touch 82 cents versus the dollar over a cyclical horizon. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been positive: Exports increased from CHF 16.7 billion to CHF 18.7 billion in September and imports increased from CHF 13 billion to CHF 15.4 billion. As such, the trade surplus slightly narrowed from CHF 3.5 billion to CHF 3.3 billion. The Swiss franc increased by 0.2% against the US dollar this week. Since the March 19 lows, the franc has appreciated by nearly 10% against the US dollar. The unwanted strength in the Swiss franc has been a headache for the SNB. We believe the intervention from the SNB will limit how far the franc can rise, compared to other G10 currencies. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been negative: The unemployment rate rose from 5.2% to 5.3% in August. The participation rate dropped by 0.4% to 70.9% in Q3 compared with the same quarter last year. On a positive note, industrial confidence continues to rebound. The Norwegian krone soared by 1.2% against the US dollar this week. As we frequently highlight in our publications, the Norwegian krone is poised to benefit most from a weaker USD. Moreover, our PPP model shows that at 30% below its fair value, the krone is still the most undervalued DM currency. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 There has been no significant data release from Sweden this week. The Swedish krona fell by 0.6% against the US dollar this week. Reuters polls now suggest that the Swedish economy is expected to shrink by only 4% in 2020, rather than by 5% as was previously forecast. The Swedish krona is one of the cheapest currencies in the G10 and will benefit from a post-pandemic recovery. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights The US saves too much to achieve full employment but not enough to close the current account deficit. According to the “Swan diagram,” a weaker dollar would move the US economy closer to “external” and “internal” balance. Structural forces are unlikely to have much effect on the value of the dollar over the next few years: The neutral rate of interest is higher in the US than in most other developed economies; the US still earns more on its overseas assets than it pays on its liabilities; and there is no meaningful competition to the dollar’s reserve currency status. Cyclical forces, in contrast, will become more dollar-bearish over the coming months: A vaccine would buoy the global economy next year; interest rate differentials have moved sharply against the dollar; and further fiscal stimulus should lift US inflation expectations. Stocks tend to outperform bonds when the dollar is weakening. Investors should remain overweight global equities on a 12-month horizon, favoring non-US stocks and cyclical sectors. A Clash Of Views? Today marked the last day of BCA’s Annual Investment Conference, held virtually this year in light of the pandemic. As in past years, it was a star-studded cavalcade of the who’s who in financial and policymaking circles. I always find it interesting when two of our speakers seemingly disagree on a critical issue. Such was the case with Larry Summers and Stephen Roach. Larry kicked off the proceedings with an update of his secular stagnation thesis. He argued that his thesis had gone from “a hypothesis that needed to be considered” to a “presumptively accurate analysis of the status quo.” In Larry’s mind, the core problem facing the US and most other economies is a surplus of savings. Excess savings results in a chronic shortfall of spending relative to an economy’s productive capacity. Faced with the challenge of maintaining adequate employment, central banks have been forced to cut rates to extraordinarily low levels. Perpetually easy monetary policy has periodically spawned destabilizing asset bubbles. Larry recommends that governments ease fiscal policy in order to take the burden off central banks. Later that morning, we heard from Stephen Roach. Stephen expects the real US trade-weighted dollar to weaken by 35% by the end of next year. What’s behind this bearish forecast? The answer, according to Stephen, is that the US economy suffers from a shortage of savings. Unable to generate enough domestic savings to cover its investment needs, the US has ended up running persistent current account deficits. How can the US be saving too much, as Larry Summers claims, while also saving too little, as Stephen Roach insists? The two views seem utterly unreconcilable. In fact, I think there is a way to reconcile them with something called the Swan diagram. The Swan Diagram True to the reputation of economics as the dismal science, the Swan diagram – named after Australian economist Trevor Swan – depicts four “zones of economic unhappiness” (Chart 1). Each zone represents a different way in which an economy can deviate from “internal balance” (full employment and stable inflation) and “external balance” (a current account balance that is neither in deficit nor in surplus). Chart 1The Swan Diagram And The Four Zones Of Unhappiness The four zones are: 1) high unemployment and a current account deficit; 2) high unemployment and a current account surplus; 3) overheating and a current account deficit; and 4) overheating and a current account surplus. The horizontal axis of the Swan diagram depicts the budget deficit. A rightward movement along the horizontal axis corresponds to an easing of fiscal policy. The vertical axis depicts the real exchange rate. An upward movement along the vertical axis corresponds to a currency appreciation. The external balance schedule is downward sloping because an easing of fiscal policy raises aggregate demand (which boosts imports, resulting in a current account deficit). To restore the current account balance to its original level, the currency must weaken. A weaker currency will spur exports, while curbing imports. The internal balance schedule is upward sloping because an easing in fiscal policy must be offset by a stronger currency in order to keep the economy from overheating. The US presently finds itself in the top quadrant of the Swan diagram: It saves too much to achieve internal balance, but not enough to achieve external balance. From this perspective, both Larry Summers and Stephen Roach are correct. Unlike the US, the euro area, Japan, and China run current account surpluses. Rather than pursuing currency depreciation, the Swan diagram says that all three economies would be better off with more fiscal easing. What It Would Take To Eliminate The US Trade Deficit By how much would the real trade-weighted US dollar need to weaken to achieve external balance? According to the New York Fed, a 10% dollar depreciation raises export volumes by 3.5% after two years, while reducing import volumes by 1.6%.1 Given that exports and imports account for 12% and 15% of GDP, respectively, this implies that a 10% dollar depreciation would improve the trade balance by 0.12*0.035+0.15*0.016=0.7% of GDP. Considering that the trade deficit is around 3% of GDP, the dollar may need to weaken by 30%-to-50% to eliminate the trade deficit, a range which encompasses Stephen Roach’s projection for the dollar’s decline.  Don’t Hold Your Breath In practice, we doubt that the dollar will decline anywhere close to that much. Despite a net international investment position of negative 67% of GDP, the US still generates substantially more income from its overseas assets than it pays to service its liabilities (Chart 2). This reflects the fact that US foreign liabilities are skewed towards low-yielding government bonds, while its assets largely consist of higher-yielding equities and foreign direct investment (Chart 3). Chart 2The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities Chart 3A Breakdown Of US Assets And Liabilities Given that the Fed will keep rates on hold at least until end-2023, it is unlikely that US government interest payments will rise substantially in the next few years. Faster Growth Helps Explain America’s Chronic Current Account Deficit The neutral rate of interest is higher in the US than in most other developed economies. Economic theory suggests that global capital will flow towards countries with higher interest rates, producing current account deficits (Chart 4).2 Chart 4Interest Rates And Current Account Balances The higher neutral rate in the US can be partly attributed to faster trend GDP growth. There are three reasons why faster growth will raise investment while lowering savings, thus leading to a current account deficit: Faster-growing economies require more investment spending to maintain an adequate capital stock. For example, if a country wants to maintain a capital stock-to-GDP ratio of 200% and is growing at 3% per year, it would need to invest (after depreciation) 6% of GDP. A country growing at 1% would need to invest only 2% of GDP. Governments may wish to run larger budget deficits in faster-growing economies in the belief that they will be able to outgrow their debt burdens. To the extent that faster growth may reflect productivity gains, households may choose to spend more and save less in anticipation of higher real incomes in the future. While trend growth is just one of several factors influencing the balance of payments, in general, the evidence does suggest that fast-growing developed economies such as the US and Australia have tended to run current account deficits, while slower-growing economies such as the euro area and Japan have generally run current account surpluses (Chart 5). Chart 5Fast-Growing Developed Economies Tend To Run Current Account Deficits, While Slower- Growing Economies Tend To Run Surpluses The Dollar’s Reserve Currency Status Is Not In Any Jeopardy Even if many commentators do tend to overstate the importance of having a reserve currency, the dollar’s special status in the global financial system will still provide it with support. The US dollar’s share of global central bank reserves stood at 61.3% in the second quarter of 2020, only modestly lower than where it was a decade ago (Chart 6). While the euro area is not at risk of collapse, it remains an artificial political entity. China’s role in the global economy continues to increase. However, the absence of an open capital account limits the yuan’s appeal. Chart 6The US Dollar’s Share Of Global Central Bank Reserves Has Barely Fallen Then there’s the dollar’s first mover advantage. During our conference, Marc Chandler likened the greenback to the QWERTY keyboard: It may not be perfect, but like it or not, it has become the default choice for typing.  I like to equate the dollar’s role with that of the English language. When a Swede has a business meeting with another Swede, they will speak in Swedish. However, when a Swede has a business meeting with an Indonesian, chances are they will speak in English. By the same token, when a Swede wants to purchase Indonesian rupiah, the bank is unlikely to convert krona directly to rupiah since the probability is low that many people will just happen to be looking to exchange rupiah for krona at precisely the same time. Rather, the bank will first convert the krona to US dollars and then convert the dollars to rupiah. The dollar is the hub of the global financial system. Just like the pound remained the global currency long after the sun had set on the British Empire, King Dollar will endure for many years to come. Cyclical Forces Will Drive The Dollar Lower Chart 7The Dollar Is A Countercyclical Currency The discussion above suggests that structural forces are unlikely to have much effect on the value of the dollar for the foreseeable future. Cyclical forces, in contrast, will become more dollar-bearish over the coming months. The US dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 7). According to the Good Judgment Project, there is a 43% chance that a Covid vaccine will be available by the first quarter of 2021, and a 91% chance it will be available by the end of the third quarter (Chart 8). A vaccine would supercharge global growth, causing the dollar to weaken.   Chart 8When Will A Vaccine Become Available? Interest rate differentials have moved considerably against the dollar – more so, in fact, than one would have expected based on the fairly modest depreciation that the greenback has experienced thus far (Chart 9). Chart 9A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials Chart 10Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US   An open question is how additional fiscal support will affect the dollar and other financial assets. Equity investors have brushed off the dwindling prospects for a pandemic relief bill before the election on the assumption that a “blue sweep” will allow the Biden administration to enact even more stimulus than was possible under President Trump and a Republican senate. The dollar rallied in the weeks following Donald Trump’s victory. The dollar also surged in the early 1980s after Ronald Reagan lowered taxes and raised military spending. A key difference between now and then is that real interest rates rose during both of those two prior episodes. Today, the Fed is firmly on hold. This implies that real rates are unlikely to rise much, and could even fall if inflation expectations move up in response to easier fiscal policy. Stocks tend to outperform bonds when the dollar is weakening (Chart 10). In particular, stock markets outside the US often do well in a soft-dollar environment. Investors should remain overweight equities on a 12-month horizon, favoring non-US stocks and cyclical sectors.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Mary Amiti, and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Liberty Street Economics, (July 17, 2015). 2 There are many different ways to measure the neutral rate. As depicted in Chart 4, capital flows tend to equalize the neutral rate across countries. This is another way of saying that the neutral rate would be higher in the US were it not for the fact that the US runs a current account deficit.   Global Investment Strategy View Matrix Current MacroQuant Model Scores ​​​​​​​

  Chart Of The WeekInvestor Consensus Is Bearish On Dollar Today we are releasing another issue from our series Charts That Matter. Going forward, this publication will become a regular monthly deliverable to our clients. This is a charts-only report with minimal wording. It presents the key charts, indicators, and relationships that we monitor at the time of publication. Needless to say, the importance of different indicators and factors varies over time. Thus, each issue of Charts That Matter will present different charts, indicators and relationships. Presently, global assets are experiencing a tug-of-war. On the one hand, equity and credit markets are overbought and have elevated valuations. On the other hand, expectations of a large US fiscal stimulus package are sustaining prospects of continued US and global economic recoveries. We have been expecting a pullback in risk assets before year-end due to a delay in significant US fiscal stimulus, potential volatility around the US elections as well as overbought conditions in risk assets. In addition, since April commodities prices have benefited from China’s growth recovery as well as inventory restocking (see Charts on page 11). Given that the latter is likely to be followed by a destocking phase, we believe resource prices are at a risk of experiencing a setback. This will weigh on commodity-producing emerging markets.   The correction in September has been short circuited. It seems the prospects of an eventual large US fiscal stimulus package, even if it is next year, and the ongoing recovery in China (Charts on pages 8-9) are sustaining a bid under risk assets. Besides, cash on the sidelines has not been fully exhausted (Charts on page 6). Consistently, we illustrate on pages 3 that various US equity indexes are presently trying to break out and that the US equity market breadth has recently been strong. In contrast, EM equity breadth has been very weak (Chart on page 4). The latest rebound in the EM equity index has been again narrow, led by mega-cap new economy stocks in China, Korea and Taiwan. Provided such poor EM equity breadth in both absolute terms and relative to the US, we are reluctant to upgrade EM equities from neutral to overweight in a global equity portfolio. As to absolute performance, the Charts on pages 12-18 illustrate that many market-based indicators are flagging yellow or red lights for EM risk assets. Even though we turned structurally bearish on the US dollar in early July, we currently expect a tactical rebound in the greenback. Investor sentiment on the greenback is very depressed, which is positive for the US dollar from a contrarian perspective (Chart of the Week on page 1). In short, global financial markets are due to reset, which will not be long-lasting but will be meaningful and produce a better entry point. For now, we maintain a neutral allocation to EM stocks and credit markets within global equity and credit portfolios, respectively.  In the currency space, we are short several EM currencies – BRL, CLP, ZAR, TRY, KRW and IDR – versus a basket of the euro, CHF and JPY. As to local rates, we are long duration – receiving 10-year swap rates in several countries – but are reluctant to take on currency risk at the moment. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Equities Have Been Trading Well Various US equity indexes have broken out to new cyclical highs. This is a sign of a broad-based rally. Chart I-1US Equities Have Been Trading Well Chart I-2US Equities Have Been Trading Well   Equity Market Breadth Is Strong In The US But Poor In EM The advance-decline line for the US equity market has rebounded from the neutral level of 0.5. On the contrary, the same measure for EM stocks remains below the 0.5 line, signaling poor breadth despite the rebound in the EM equity index. Chart I-3Equity Market Breadth Is Strong In The US But Poor In EM The World Economy And Global Trade Are Reviving Economic data for September continue to register a sequential revival in business activity in most parts of the world. Chart I-4The World Economy And Global Trade Are Reviving Chart I-5The World Economy And Global Trade Are Reviving The US: Cash On The Sidelines Has Declined But Is Not Exhausted US institutional and money market funds presently amount to 8.5% of the value of the US equity market cap plus all US-dollar denominated bonds available to investors. The Fed and commercial banks hold $11 trillion of debt securities. This amount of securities has been withdrawn from the market and is not available to non-bank investors. Chart I-6The US: Cash On The Sidelines Has Declined But Is Not Exhausted Chart I-7The US: Cash On The Sidelines Has Declined But Is Not Exhausted   A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy US fiscal transfers have produced a surge in household disposable income, which through consumer spending have contributed to the global recovery via a widening trade deficit. In the absence of large fiscal transfers to consumers, the opposite dynamics will prevail. Chart I-8A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy Chart I-9A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy   The Business Cycle In China Is Recovering China’s domestic demand and production are recovering but labor market improvements are still timid. Chart I-10The Business Cycle In China Is Recovering Chart I-11The Business Cycle In China Is Recovering   China: The Stimulus Is Working Its Way Into The Economy In China, the credit and fiscal stimulus leads the business cycle by about nine months. Thereby, China’s recovery will continue until the end of Q2 2021. Chart I-12China: The Stimulus Is Working Its Way Into The Economy Chart I-13China: The Stimulus Is Working Its Way Into The Economy   China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth The PBoC has withdrawn liquidity, pushing up the policy rate and bond yields. With a time lag, money and credit growth will eventually roll over. But for now, China is enjoying another period of credit splurge and the credit excesses are getting larger. Chart I-14China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth Chart I-15China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth   China: From Commodities Restocking To Destocking? Chinese imports of many commodities have been super strong since April. However, they have substantially outpaced their final demand. This suggests there has been an inventory restocking phase. This will likely soon be followed by a period of destocking when Chinese imports of resources dwindle for several months. Chart I-16China: From Commodities Restocking To Destocking? Chart I-17China: From Commodities Restocking To Destocking?   Red Flags For EM Currencies The rollover in platinum prices and pick-up in EM currency volatility (shown inverted on the bottom panel) point to a rebound in the US dollar and a relapse in EM exchange rates. Chart I-18Red Flags For EM Currencies Yellow Flags For EM Equities The new cyclical high in EM share prices has not been confirmed by a new low in EM equity volatility (the latter shown inverted in the top panel). Moreover, our Risk-On/Safe-Haven Currency ratio has been trending lower since June, flagging risks to EM assets. Finally, global ex-TMT stocks are struggling to break above their June highs. Chart I-19Yellow Flags For EM Equities EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Commodities prices and EM currencies drive EM sovereign and corporate spreads while EM corporate bond yields (shown inverted in the bottom panel) correlate with EM share prices. Chart I-20EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Many Currencies Against The US Dollar Are At Critical Resistances If these currencies break out of these technical resistance levels, they will experience a lasting appreciation versus the US dollar. However, in our view, they will initially weaken before breaking out next year. Chart I-21Many Currencies Against The US Dollar Are At Critical Resistances Chart I-22Many Currencies Against The US Dollar Are At Critical Resistances   Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Many defensive equity sectors have reached or are close to their technical support lines. Their outperformance will likely occur during a risk-off period. Chart I-23Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Chart I-24Are Global Defensive Equity Sectors On A Cusp Of Outperformance?   These Markets Have Not Yet Entered A Bull Market  These markets have rebounded to their technical resistance lines but have so far failed to break out. This gives us comfort to remain neutral on EM by expecting a pullback. Chart I-25These Markets Have Not Yet Entered A Bull Market Chart I-26These Markets Have Not Yet Entered A Bull Market   Risk Measures Signal Modest Investor Complacency The SKEW index for the S&P 500 is low, entailing that investors are not hedging tail risks. The put-call ratio is not elevated despite many investors hedging against the US election uncertainty. Critically, the Nasdaq’s volatility is in a bull market. Chart I-27Risk Measures Signal Modest Investor Complacency Chart I-28Risk Measures Signal Modest Investor Complacency   EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Outside China, Korea and Taiwan, EM domestic demand recovery is very slow and tame. In these economies, the fiscal stimulus has been small, the banking system is unhealthy and the monetary transmission mechanism is broken, i.e. banks are failing to properly transmit monetary easing into the real economy. Chart I-29EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Chart I-30EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations