USD: Staying calm? - Rabobank

It is glaringly obvious from the tumbles in stock markets that the market is currently re-evaluating the risk of inflation and the outlook for financing costs, according to Jane Foley, Senior FX Strategist at Rabobank.  

Key Quotes

“If inflation were to raise its ugly head in the US, this would clearly have ramifications for Fed policy and the value of the USD.  That said, there is plenty of evidence that many investors in other assets classes are holding their nerve reasonably well.  This can be largely explained by the strength of economic fundamentals.   A sharp rise in the value of the USD, however, could indicate a second wave of market risk.”

“Data from the BIS show that since the financial crisis there has been a sharp increase in the level of USD denominated loans to borrowers outside the US. A high levels of indebtedness in a foreign currency clearly means that the local economy is more exposed to exchange rate fluctuations.  It also implies that the local economy is affected by the decision of the central bank in control of the funding currency.  The weakness of the USD through last year will have had a significant effect in the cheapening debt servicing costs of this dollar denominated debt.  It follows that a USD appreciation, caused by a more hawkish Fed, would have the opposite effect.  A study published by the BIS last month titled “the dollar exchange rate as a global risk factor” concluded that a stronger US dollar is associated with lower real investment in emerging markets.  In other words a sharp reduction in USD liquidity could have ramifications well beyond the US borders.”

“That said, there is no sign that the emerging markets are lining for a repeat of 2013’s taper tantrums. This was triggered by a testimony of then Fed Chair Bernanke which raised the possibility of the Fed tapering its QE programme.  Not only have EM FX flows remained relatively well ordered this week but demand for safe havens currencies has also been confined considering the extent of the moves in equity markets.  The USD is one of the better performer in the G10 universe over the past 5 days, reflecting a higher level of anxiety.  However, the upside is mostly modest and the greenback has registered little net change vs. the CHF, EUR and JPY in this period.”

“Certainly there has been a lot of news recently feeding US inflation expectations. Clearly the 2.9% y/y print for US January average earnings was a surprise.  However, this is still lower than the level of wage inflation at the tops of previous US economic cycles.  The fact that wage inflation remains weak in many G10 economies is suggestive of structural factors which will likely continue to limit upside potential in earnings created by tight labour market conditions.”

“Low wage inflation implies soft growth in consumer demand and it is still out house view that core inflation in the US is sufficiently benign to prevent the Fed from hiking interest rates more than twice this year. Assuming that new Fed Chair Powell does offer reassurances that the Fed will continue to reduce liquidity at a slow pace, this is likely to offer reassurances to global investors and the outlook for USD should remain in check.  Although there has been a notable re-pricing in US bond yields since the start of the year on the back of a rise in inflation expectations and supply concerns, the value of the 10 year t-note yield is this morning holding comfortably below yesterday’s high.”

“The lack of aggressive contagion into FX markets supports the view that the breath-taking plunge in stock market valuations over the past few sessions can be explained as corrective activity.  For the rout to extend its reach further we would likely have to expect a more a rapid pace in normalisation of policy by central banks and a sharp appreciation of funding currencies, in particular the USD.  It has been said of Powell that the most difficult part of his new job will be implementing a reduction of USD liquidity while keeping market sentiment calm.  One thing that is clear is that Powell has learnt very early on in his job how tricky this might be.   Our relatively dovish view on the Fed supports our view of a move towards EUR/USD1.28 on a 12 mth view followed by a period of consolidation around current levels on a 1 to 3 mth view.”