USD: A fresh look - Rabobank

Jane Foley, Senior FX Strategist at Rabobank, explains that following last week’s turmoil, the S&P 500 Index has managed its biggest 2 day advance in 18 months and the DXY dollar index has softened as a consequence of the improvement in risk appetite. 

Key Quotes

“Even if hindsight will eventually allow the market to put last week’s plunge in stocks down to an inevitable, albeit drastic correction there will be some legacy impact on market sentiment.  For the FX market this is likely to be related to the perceived impact on USD liquidity provision from the risk of firmer inflation, greater supply of debt issuance in the US and the likelihood of higher rates across the curve.”

“According to the BIS, the amount of outstanding USD denominated securities issued by emerging market economies rose from USD509 bln in 2008 to USD1.25 trn as of end September 2016. Around 40% of this was issued by non-financial corporations.  Total USD debt (including bank loans) of emerging market non-bank borrowers stood at a very sizeable USD3.6 trn at the end of September 2016.  To give this some perspective, as a proportion of GDP, the BIS estimates that emerging market debt in foreign currencies is still below the levels observed ahead of the financial crisis.  The composition is also different insofar as longer dated debt issuance has partly replaced bank loans.  In addition, emerging market economies in general have much larger reserve buffers than in the 1990s.  While this suggests a greater resilience of emerging markets to higher interest rates and a firmer USD, it does not mean that the prospect of less liquidity provision will not be a headwind.”

“Asian emerging markets are generally considered to be most vulnerable to a tightening of USD liquidity. These concerns can be expected to intensify should fears of trade wars increase.  Central and Eastern European markets have less trade and financial links with the US and should be less impacted by specific market concerns about US interest rates.   Within Asian, economies such as Malaysia and Indonesia are often considered to be among the most vulnerable to a reduction of USD liquidity due to their relatively large per capital debt offshore USD borrowings.  True to form, measured from the start of last week, the MYR and the IDR are among the worst performing emerging market currencies.  The worst performers in this time frame were the BRL, COP and ARS although carnival season market closures, commodity prices and domestic politics have all had an impact.”

“Last September the Federal Reserve signalled that it would slowly start to reduce its enormous USD4.5 trn balance sheet. This started in October with a USD10 bln reduction.  Gradually the amounts of debt that the Fed will not roll over will drop such that the balance sheet could decline by upwards USD420 bln this year.  In an essay published in January 2017, former Fed Chair and instigator of 2013 ‘taper tantrums’ Ben Bernanke emphasised that the balance sheet reduction process would be carried out to minimise market disruption.  He also pointed out that “because of rising nominal GDP, low interest rates, increased foreign demand for dollars and other factors, Fed staff estimates that, the amount of currency in circulation will grow to $2.5 trillion or more over the next decade” and determined that “growth in the public’s demand for currency alone implies that the Fed will need a much larger balance sheet (in nominal terms) than it did before the crisis”.”

“The assumption that the Fed’s balance will ultimately stay at a level far larger than before the financial crisis should reassure concerns about USD liquidity. However, insofar as a Fed study suggests that the effect of its whole QE programme was to reduce the 10 yr t-note yield by 120 bps in 2013, it still follows that the reduction could yields higher.  Concerns about additional debt supply to fuel a more expansionary fiscal position in the US has also been supportive for yields.”

“We retain the view that moderate wage inflation and contained price pressures will cap the outlook for yields. That said, we have entered into an environment of less cheap USDs and reduced liquidity. In general terms this should support the USD vs. various high yield currencies.  We are forecasting that the value of the USD will rise this year vs. a broad range of EM currencies in addition to the AUD and the NZD. That said, we expect that the EUR is likely to hold up well against the USD this year given the relatively better budget position in Eurozone countries vs. the US and the region’s huge current account surplus. In the coming weeks we are expecting to see more consolidation in EUR/USD around current levels with a modest upside bias on a 3 mth view assuming risk appetite stabilises.”