The Surprisingly Front-Loaded Dollar Decline - Global Exchanges

Greg Anderson:

Hi, I'm Greg Anderson from BMO FX Strategy. Welcome to episode 61 of Global Exchanges, a podcast about foreign exchange markets and related issues.

In this week's episode, my co-host Stephen Gallo and I talk through the ongoing downtrend in the US dollar, with particular mention of where things might go from current levels in euro/dollar, GBP/USD and dollar/yen. The title of this week's episode is, The Surprisingly Front-Loaded Dollar Decline.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to BMOCM.com/globalexchanges. Thanks for joining us.

Stephen Gallo:

Okay, very warm welcome. Thanks for tuning in. It's January 17th, 2023. And Greg, you know this is a provocative subject area that we're addressing today for a number of reasons, this subject of the dollar decline. I'm going to just name a few of those reasons.

Firstly, because it comes as a bit of a surprise to us. We had baked in the bulk of the dollar weakness for this year at the back end rather than the front end. So as I say, this move has taken us by surprise. Secondly, because I think 2022 was such a traumatic year for markets and investors, it now seems like instead of bad news all the time, all news is basically good news based on the way that many markets trade. And thirdly, I think the subject of the dollar provokes debate amongst investors because many are questioning whether the events related to the pandemic, the war and then the aftermath were just a blip, versus the view that the world has fundamentally changed and gone into some kind of a reset.

So with that groundwork laid, and with that in mind, let's dig through the numbers and then I'll pass the mic over to you, Greg. So two weeks into the new year and the Bloomberg Dollar Index, we've got it down 1.7% is down 2.1% since the December FOMC, so that's an important benchmark. Now, what intrigues me is that the race market has been fairly consistent in pricing in rate cuts from the Fed as early as the second half of 2023, but as we've been saying in multiple publications and media blasts and so on, this dollar move seems to have less to do with the Fed and a lot more to do with reduced chances of a global economic hard landing. Why don't you take it from there, Greg?

Greg Anderson:

So Stephen, you've brought up a good point with the consistent pricing in of Fed rate cuts. I was just looking back at the closing data from December 12th, which was two days prior to the December FOMC. At that point, the Fed fund's futures market had the peak of the curve at 4.98% after the May meeting with 43 basis points worth of cuts between then and the end of this year. Today, we have the peak of the curve at 4.91% in June with 46 basis points worth of cuts in the back half of this year.

Yeah, that does mean that FFZ3 is implying an end of year rate that is 10 basis points lower than pre-FOMC a little over a month ago. But frankly, 10 basis points is not a lot of movement in the grand scheme of things. It's definitely not the kind of movement that I would say should be associated with a 2% US dollar decline at, as you mentioned, between that FOMC and now.

And now if we look back a couple of months further, we're actually down about 9% in the US Dollar Index since mid-October, which that's when I would say that global recession angst was the most pronounced in financial markets. At that stage a global recession in 2023 looked like a really high probability scenario. It seemed then like there were three things that could happen.

One, the Fed could end up having to trigger a global recession due to sticky and runaway inflation. Two, a winter energy crisis in Europe could cause a recession there that would propagate out to the rest of the world. Or three, China's exit from COVID zero policies could go badly and cause a Chinese recession that propagated to the rest of the world. I'll just say that from where we stand today, things look a whole lot better through all three of those channels of risk.

As a result, equities of rallied hard, copper is caught a bit, credit spreads of narrowed, et cetera, et cetera. And to me, this is the primary factor behind US dollar weakness, rather than FFZ3 implying in 10 basis points lower Fed rate 11 months from now.

All that said, Stephen, I now want to turn this back over to you. We were at, call it, 95 to 98 cents in euro/dollar just three short months ago, and here we are today trading on a 108 handle. So we're talking a 10% rally in the euro. Have we gone too far too fast with this?

Stephen Gallo:

Thanks for bringing up euro/dollar, Greg. I'm glad you did. Based on the positioning of leverage funds basically neutral and the negative carrier associated with a long euro/dollar position, I think the pair is starting to approach ranges, which I would consider a bit stretched short term, but on balance, this move in euro/dollar is not one that I would fight aggressively yet, Greg. And I think we could see levels close to 110 are at the figure before we see 105 again. And just to be clear, I do subscribe to the view that there has been something of a reset in the global economy, which is likely to cause more volatility in inflation, more trade friction, more fiscal risk and more geopolitical risk than we were used to a decade ago. But that's the bigger picture.

The smaller, I guess, short term picture is that after a traumatic 2022, all news right now seems to be good news as investors discount the prospect of a less severe downturn into global financial variables, just like I noted in my first segment, and you went through this a bit in your last segment, Greg, and just think about the current short term backdrop. The war on Ukraine is basically at a stalemate. Putin has not been able to weaponize winter weather conditions to his advantage. Investors are busy pulling out economic hard landing risk for the global economy. Europe will feed off China's reopening on a number of different fronts, and inflation pressures are clearly moderating. I also think you're seeing many investors who have been sitting on the sidelines, they're now anxious to get involved moving money out of cash. So I don't think I could encourage an FX trader to fight these forces at the moment.

But here's also what I'll say and I'll pass the mic over to you, Greg. At least two things concern me. First, if we're not going to have a hard landing, commodity prices aren't going to collapse, China is rebounding and financial conditions are set to remain looser than they were for most of last year, I'm concerned about an abrupt reversal in euro/dollar if inflation starts to disappoint again. That might not happen this month. It might not happen next month, but it could happen in the spring or by the time we get to the middle of the year, especially if leverage funds get net long of euro/dollar.

The second thing that concerns me, I guess second thing on the list, is how central banks respond to the fact that economic hard landing risks are dropping and markets are countering monetary tightening to a degree with looser financial conditions. I don't know if it completely offsets what the central banks are doing, but we've already heard central bankers chime in about this. In my opinion... Well, I don't really have an opinion on what central banks can do to stop this dynamic, but you're the economist in the room, Greg, what do you think about what's going on in this regard?

Greg Anderson:

When G7 and G20 central bankers and finance ministers got together back in October, I'm sure that the extreme strength of the US dollar at that time was a big concern. So coming out of that confab, the ECB became more hawkish, the MOF went to its so-called stealth intervention in dollar/yen, and the Fed began to foreshadow its downshift in terms of the pace of rate hikes. I think all of these things were designed to cool the pace of the dollar rally. However, I doubt those officials expected the US dollar to reverse as hard as it has.

So, now if they think the reversal has gone too far, what can the Fed and others do at this stage? I guess let me first point out that their next formal confab isn't until February 22nd in India. And yeah, maybe some of them could coordinate informally prior to then, but I don't think we should expect a noticeably coordinated response until late February at the earliest. So until then, that puts the onus on individual action. I do expect the Fed to do what it can to counter the optimism that is bubbling up because that optimism causes financial conditions to improve and they don't want that. If I could paraphrase and extend Powell's November 30th speech just a little bit, he said then that the US has a tight labor market primarily due to what he termed excess retirements. For at least the next 12 months or so. I think the Fed wants people in their sixties to feel like they can't afford to retire because the US economy needs them to stay in the labor force to balance labor supply with labor demand.

Now, I don't think that Powell would directly say that he doesn't want equities to rally or the US dollar to sell off, but I expect that he and other FOMC members will reiterate repeatedly that they want financial conditions to remain tight. And on February 1st in the post FOMC press conference, Powell can reiterate the 5.1% median dot and emphasize that the Fed intends to hold at the terminal rate for a long time in an effort to try and talk those H2 rate cuts out of the curve.

Now, is this enough to turn the tide in global markets? I guess I'll admit it's probably not. To really turn market sentiment and arrest this US dollar decline trend, I think that the way that policymakers could do that would be to threaten to speed up the pace of QT, and that I think would really do the trick. Look, maybe that's what the Fed should do if it gets a terminal and optimism as reflected in a falling USD, rising commodity prices and rising equities is just more exuberant than the Fed would like. But look, admittedly that that's a really big paradigm shift for the Fed to bring up QT pace before hitting terminal because the Fed has told us that they want the balance sheet to be a background policy while rate policy is the foreground policy.

All that said, Stephen, now let me turn it back to you. Do you think the ECB wants the euro to rally further from here?

Stephen Gallo:

Greg, I'll keep it brief so we can keep the ball rolling forward. I don't think any central bank, including the ECB, mines a stronger currency right now. In the case of the ECB, there isn't really much they can do about it anyway for the time being because the euro has a high correlation with global economic cycles and global growth expectations, they're both moving up, as we've said a number of times in this podcast already. Secondly, the euro rally is associated with the euro area's current account balance improving and euro appreciation has the potential to extend the improvement by suppressing import costs.

So I don't think the ECB would be very bothered by 110 in euro/dollar in the short run if that's where we get to in the currency pair, but I also think they probably wouldn't be that tolerant of a sustained move above that level if we hold all factors constant that we've been talking about in this podcast. Obviously, a too strong euro is not palatable for exporters because it raises the external sales price of euro area exports for their customers. And a too strong euro is also not politically palatable internally within the euro area because it tends to lead to protectionism, which is, I think troublesome to a handful of euro area member states and also countries that trade with the euro area.

Greg Anderson:

Okay, Stephen, so along those lines, GBP/USD has also rallied about 10% since October, and of course it's up nearly 20% from the panic low in September. What are your thoughts there? Is the recovery overextended? And in which direction do you think a five big figure move is more likely?

Stephen Gallo:

Nice handoff on sterling, Greg, I think it's a good topic. Look, since late September, early October, I've been saying buy dips in cable, that strategy seems to have worked. I still think sterling versus the dollar is moderately cheap compared to what some investors might refer to as long run equilibrium. But if you're talking about the next big five big figure move in cable, I'd probably say to the upside. With that in mind though, I'd probably also argue that the same long run equilibrium level for cable is in a secular decline for a variety of structural reasons, UK specific, but I'll part that conversation for another day.

You said five big figure move, Greg, what about the next two to three big figure move? And on that one, I'd probably lean to the downside. Maybe I'm being a bit greedy here and I see better short-term value buying sterling at or just below 120, but look, this would be my trading strategy in cable. When we see clear evidence for a month or two that price and weight pressures are declining materially as I think they will for a time, I'd buy the dip in sterling even if it coincides with UK yields moving lower and portions of the yield curve starting to bull steepen. What would cause me to ditch the pound entirely though if I were long, would be a very slow economic growth trajectory, but at the same time, very little progress on inflation or pay growth moderation.

With that other way let's touch on the yen, Greg. The balls in your court, do I want to be short dollar/yen here?

Greg Anderson:

I wouldn't want to be short dollar/yen here, but maybe I'm more of a counter puncher than is optimal. This one is tricky because we are recording roughly 12 hours ahead of a BOJ policy decision and based on the timetable of our podcast, we sort of know that most people will be listening to this episode post BOJ. So trying to take that out of the equation, this is what I'd say. I view the number one fundamental in dollar/yen to be the US bond market, which I'll simplify just to the price of the ETF known as GOVT. When GOVT goes down like it did for the first 10 months of last year, then dollar/yen goes up due to FX hedge adjustments. And when GOVT goes up like it has thus far in 2023, then dollar/yen goes down. But looking at the scale of the movements, the dollar/yen move lower this year is just much, much bigger than the GOVT move higher. And as I noted before, I think the Fed will do what it can to suppress the price of GOVT from rallying any further.

Behind GOVT, my second most correlated factor with dollar/yen is the price of Brent Crude, with Japan being almost entirely reliant on imported energy. It's the same story here. We have yen strength that has dramatically outstripped energy price softness. So casting aside the whole BOJ consideration, I personally wouldn't want to be short of dollar/yen anywhere south of 135. Doing so is it's fighting against the carry, it's fighting against the Fed and maybe also fighting against the BOJ at this point.

Stephen Gallo:

I think we've squeezed this towel dry enough, and we've got enough content here to last us a week. I'm going to wrap things up. Thanks for tuning in if you stuck with us. Bye for now.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:

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Greg Anderson:

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Speaker 3:

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