EUR/USD: China And The End Of Cheap Dollars; What Is The Trade? - Nordea

In 2007, the (rising) price of money was in the driving seat of credit risk, now it is the dollar. China could help decide on the overall trajectory for risk appetite – potentially in Lima, and hence for liftoff and the dollar.

Is the end of cheap dollars priced-in yet?

Probably too early to price-in ECB QE2

Markets on China/commodity fallout watch

The era of cheap dollars came to an end in the middle of 2014. Unwinds of cheap dollar trades have been going on since then. Markets could indeed be experiencing a Minsky Moment, if not two, currently. In 2007, the (rising) price of money was in the driving seat of credit risk, now it is the dollar. Thankfully, spill-overs from the commodity and EM spaces on DM should be markedly smaller – negligible? – compared to spill-overs from systematically important financials in trouble...

The Fed, which has been underwriting risk appetite since 2009 (the Bernanke put) will be reluctant to do so if not financial conditions tighten enough to threaten the improvement on the labour market, which seems unlikely. This is a big change.



This does not mean that financial conditions won’t matter. One reason why the Fed opted for a wait-and-see approach in September was the gains of the dollar ahead of the meeting. When the Fed is faced with a question of whether to do what’s right for the US economy, vs to do what it has ”promised”. It will try to do what is right. Thus, if financial conditions tighten markedly ahead of December (our economists current lift-off call), Fed could delay the rate hike into 2016. Beyond the dollar story which probably has further legs, we await the impact from recent China/EM/commodity/Volkswagen/real rate worries on developed markets.



For instance, Chinese manufacturing sentiment normally leads Germany’s PMI by two months (chart 3), and while we expect European growth to remain fairly resilient, we nonetheless think it’s too early to call the all clear on China spill-overs. It could also be that we will see a negative Volkswagen effect on German and European sentiment in coming months.



As for the US, while you would rightfully argue that US lending rates remain low, empirically, changes in US real rates have predictive power on surprises in US housing market data. Not only does it seem fair to expect some modest capex retrenchment – ISM will stay depressed - owing to the aforementioned factors, housing market data will disappoint further– again not in any way which will threaten the recovery, but in a way which risks delaying market pricing of the first Fed rate hike.

If China succeeds in boosting growth and does so without allowing further currency weakness – watch the outcome after the IMF/World Bank meeting in Lima, then risk appetite will stabilize and pick up – which should be broadly USD positive. This would also allow the Fed to hike rates (higher 2y yields).

If China fails, or lets the CNY weaken further, then pressure on other central banks to ease will intensify. In this scenario, EUR seem likely to gain on risk aversion and the Fed won’t hike, at least not this year. It is probably too early for the market to discount more ECB stimulus over the next few weeks, we nonetheless think the market could start to discount ECB QE2 in November.

In the last Global FX Strategy we suggested establishing shorts should EUR/USD rise to 1.17-1.18. We stick to that view. At 1.18, the trade-weighted EUR would be 7%-9% stronger than the ECB expected in September, and the market will have a hard time seeing the ECB accept that.