What Breaks Next? - Global Exchanges

Greg Anderson:

Hi. Welcome to episode 45 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my co-host, Stephen Gallo, and I will be talking about the latest signs of distress in global markets, related to the rising US dollar, rising oil prices, and uncertainty over central bank responses to these issues. The title for today's episode is, What Breaks Next?

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.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Stephen Gallo:

Okay. It's the 14th of June, 2022. Thanks for tuning into episode 45 of Global Exchanges. As we get the show on the road, I'd like to start with a quick glance at the map, so to speak. The end of Q2 is fast approaching, and we've got a near 7% gain in the broad dollar since the end of March. The S&P 500 that is, which is a good enough proxy for global risk appetite, that's down about 17%, and the US two-year yield is higher by just over a hundred basis points. Moving back to FX, Greg, you made this shout earlier. It's a great one. The Fed's broad nominal dollar index is just 2% off its high for the 21st century. That's a pretty stunning fact. So I'm going to throw it over to you with a question before we move through the weeds of the broader FX market. We've seen dollar rallies before. We've seen selloffs and risk assets before. But there's something about this environment that just looks and feels instinctively different. What are your thoughts about the rally in the dollar, in this environment, given that context that I just mentioned?

Greg Anderson:

Stephen, I'm a pretty old guy for this industry. I was in the industry and do remember the dollar rally of the late 1990s, and that Asian crisis period from 1997 to 1998. And then call it the Euro crash upon launch period of 1999 to 2000. That was the first analog to this year's FX market that I began reaching for in my memory a few months ago. But you know what? It may turn out that the better analog is actually the dollar rally of the early 1980s. And yeah, I was alive then, but I don't have a market participant's memory. There aren't very many central bank ads and finance ministries out there who have that memory either. I guess, maybe Kuroda. He was a technocrat in the MOF at that time. But people like Powell or Lagarde, they weren't in financial markets then.

Greg Anderson:

The good news, I suppose, is that Lagarde and Powell are excellent students of history, but of course, learning about a market context from a historical perspective is a lot different from living through it and feeling it in real time. So anyway, yeah, I would say that this market feels now unlike anything experienced, at least in the 21st century, for sure. So Stephen, you mentioned the 7% dollar rally in Q2, but you didn't go through the spectrum of currencies. Do you want to do that real quick? What has outperformed and what has underperformed that 7% dollar rally?

Stephen Gallo:

Okay. So taking a look at the G10 space, what stands out to me immediately is that other than the Noky and the Kiwi, we don't see all of the commodity block currencies within the space piled up in the bottom. Noky is down close to 12% for the quarter. It's the worst performing currency in G10, but it's an extremely high beta currency, and sometimes an illiquid one. And the country's exposure to global dead and equity markets via the sovereign wealth fund magnifies the current sensitivity to risk. So minus 12% is not necessarily a clean reading on the NOK's fundamentals, but contrasting to the Noky and the Kiwi, the Canadian dollar is just 3% lower quarter to date. Aussie is 8% lower. That's a sizable move, but it's outperformed Sterling and the yen. So we're not seeing a simple growth on/growth off trade in G10 commodity currencies, like we used to. And now let's look at the yen that's down nearly 10% during the quarter.

Stephen Gallo:

And that one stands out, definitely, because I think we're so used to seeing the yen rally during periods of severe risk off. It's not doing that right now. And then when we move to EM, and generally energy exporting currencies in the EM space, or currencies with relatively small energy trade deficits in EM have done reasonably well, the ruble is up 40%, but we know capital controls and invoicing and rubles have played key roles there. Indonesia is down just 2.2%. Malaysia is down about five to 6%, but even when we go to the bottom of the list of returns, Turkey's down 15% and just above Turkey is the HUF with a spot return of minus 13%. So my point is that these are stress like moves in EM currencies, but they're not screaming that something has severely broken yet. So we've got to get to the point, what's going to break or what is break.

Greg Anderson:

I agree that for the major EMs, nothing has broken yet. There have been a couple of small countries with bigger crises for them though in Q2, which I think we should at least mention. So, Sri Lanka was running a quasi peg at around 200 rupees per dollar that it dropped in mid-March. We're now looking at an exchange rate of about 360. So, LKR has dropped what's called 45% of its value over the past three months with about half that damage coming in late Q1 and the other half in Q2. And yes, the financial crisis of the devaluation led to a social and political crisis in the country as might be expected with the real wealth decline that we're talking about. And actually there's one country's currency that has fallen even more. And that's El Salvador's. So Salvador officially dollarized in 2001, but over the past year under a government, that's not officially recognized by the US due to claims of election fraud.

Greg Anderson:

The country has also adopted Bitcoin as legal tender, and with much fanfare, the central bank announced it was converting a substantial portion of its reserves into Bitcoin. Since then, the value of Bitcoin has roughly been cut in half and talk about bad timing. But anyway, if we want to call Bitcoin El Salvador's national currency, and yeah, I know I'm being cheeky with that, but it is where president Bukele was going with things just a few months ago. Then El Salvador's currency has lost half of its value. The Sri Lanka and cryptocurrency stories are the kinds of things that propagated in the late 1990s, and I would say, were frankly endemic in the early 1980s. So, I'll just conclude by saying that crypto/El Salvador has pretty much broken this quarter, Sri Lanka definitively did break, and then everything else is showing stress, but hasn't broken yet. Stephen, you brought up a good one with the yen, but I feel like we've talked and written a lot about that already. So, I want to turn to Sterling. The British pound is down about 9% against the dollar for the quarter. So under performance with that 7% dollar move, Sterling's also down about 3% against the Euro for the quarter. So what's going on is the pound about to break with echoes of 1992 or the early 1980s.

Stephen Gallo:

Rick, you know what? Those aren't bad analogies, based on what could potentially be coming for Sterling. And yeah, perhaps we could put the pound into the list of currencies that are breaking, and I've got a few noteworthy observations from Sterling related markets today. So based on my observations, it looks like the rates market has pulled rate hike expectations lower along the 2023 portion of the yield curve. Yesterday, by my calculations, the OIS curve was pricing in roughly 249 basis points of additional BoE tightening by may next year, relative to the current 1% level of bank rate. And today, that market pricing has dropped a little bit to about 245 basis points worth of tightening. The two year guilt yield that fell by one basis point today. And I think, the main thing to point out here is that, while two year sovereign yields have risen sharply in other parts of the developed world today, the UK two year sovereign yield is down.

Stephen Gallo:

So there's definitely a growth story here, a negative one that's being reflected in the FX market and in shorter term rates, but why are longer term UK nominal yields still rising, then? As of today anyway. It's not my remit to focus on the bond market and I don't have an answer to that question, but from my perspective, it looks like investors are doubting the BoE's ability to keep up with the tightening campaigns of other major central banks. And the pound is starting to be singled out for it by the FX market. While at the same time, the risks of persistently high inflation, fiscal risks, an upended global trade environment, balance of payments concerns. They're all being wrapped into one negative story for Sterling at the moment. Greg, you mentioned the echoes of the early 1980s and 1992. I think, the one thing I'd point out is that the difference between the Sterling evaluations of the 1970s and the early eighties and in 1992, is that the currency was being allowed to adjust lower, or forced to adjust lower, from verifiably rich valuations.

Stephen Gallo:

Today, it's not as clear that the pound is as overvalued as it was during those earlier episodes. All I can say at this stage with the information I have is that there are near term downside risks for Sterling, which haven't fully played out yet or materialized. And there are reasons for the pound to stay cheap regardless of how long it takes those risks to materialize. And I think we'll get a better idea, a much better idea of how the pound is fundamentally being priced by the market as new data roll in, like data concerning the balance of payments. But I admit that could take many months to determine.

Greg Anderson:

So Stephen, in today's FX daily, you gave an outlook curve for GBP/USD that had a bottom at one 18 at the three month horizon. Is that really where you'd put the bottom? What if the Fed were to hike to 4% over the next year? And the BoE were to stop at somewhere around two 50 or something, where would you put Sterling in that scenario?

Stephen Gallo:

You know what, Greg? I'm not fully confident that 1.18 will be the flooring cable, regardless of where the expectation for UK rates is at this stage. The issue that the UK faces, like many other economies, is that while hiking rates to keep pace with the Fed, so to speak, provide some support to the local currency, tighter policy can also do a lot of damage to the domestic economy, especially if the economy in question is particularly sensitive to higher interest rates. The other issue is timing. Greg, you said 12 months for the Fed to get to 4%, which is a pretty rapid timeframe for going from 1% to 4%. And if the Fed gets to 4% relatively quickly, while the UK curve stays priced for a terminal rate at say 2.5%, I think the Fed is going to have a big negative impact on Sterling, but certainly the major floating European currencies, they're going to have a lot of difficulty in that environment too.

Stephen Gallo:

For Sterling specifically, I would just argue this if the BoE were to hike rates more than expected. Yeah, it would cause shock and consternation in the FX market. But if it looked like the BoE was doing so as growth continued to weaken notably, or if the BoE were attempting to cushion Sterling with interest rate hikes, which I don't believe they would do by the way, then I don't think Sterling's strength stemming from sharper rate increases in that environment would last very long. Now, Greg, let me flip the script on you and ask where do you think dollar yen would go if the Fed were to hike to 4% over the next year.

Greg Anderson:

So FFM3, which is the Fed fund's future for June, 2023, or call it one year plus two weeks from now, it implies a Fed funds rate of 4.05%. I admit, I'm suffering from sticker shock from that because it was just added an implied rate of 1% in December. So anyway, here we are at 4% in change. In theory, if we believe that the FX market simultaneously prices in the same central bank outlook as the rates market, today's 1.35 in dollar/yen, does price in the Fed going to 4%. However, in this instance, I doubt that the FX market has fully priced in that much Fed tightening. I think that if the Fed really does go to 4% and let's say that the BOJ gets off the dime and maybe uses the opportunity to get its base rate from minus 10 bips to plus 10 bips.

Greg Anderson:

I still think we'd be looking at dollar/yen at 1.40+. I also want to keep pointing out something else. And that's the relationship between dollar/yen and oil. I remember saying, months ago, that if oil went to 1.20, that dollar yen would too, and then I upped the numbers so that if oil goes to 1.30, dollar/yen, would too. Here we are again and I guess I'll up the antes more. If oil goes to 1.50, then I think dollar/yen will also go to 1.50. And with as tight as oil markets are, I think it's possible. I think it's possible to see both of those moves over the next three months. And then, I guess at that point, I'd lump the yen into the basket of currencies that have broken, but I'm guessing there will be a bunch of others joining the end in that basket.

Greg Anderson:

The bottom line for me, where we started this podcast, talking about things breaking in financial markets. And then we proceeded to spend a bunch of time talking about the Fed breaking things. I just want to say that, while I do think that Fed induced US dollar strength is a really important stress contributor in financial markets right now. I frankly think that oil is just as important of a stress inducer. And an oil spike could "break" a bunch of other currencies, quasi currencies and related financial instruments. And that's something we've got to tightly monitor alongside the Fed right now.

Stephen Gallo:

Greg, let's draw a line under this. To sum up, I think we can conclude that we believe there will be other shoes to drop as the summer rolls on. And in terms of what could be breaking now, we might want to put Sterling in that list and we might do the same with the end. So we've got two G10 currencies at or near breaking point. That's a pretty big deal. Anything else you want to add, Greg?

Greg Anderson:

Well, I wish there weren't many more things likely to break so that we could all take a few weeks off during the summer without worrying a lot about markets. That just doesn't look likely in 2022, it's going to be a hot summer in FX, I think.

Stephen Gallo:

Time to wrap up. Thanks for joining us, if you stuck it out for this long. Until next time, 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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