That price acts as a narrative coalescing agent is empirically evident. The gravity associated with Trending price momentum invariably attracts a layering of narrative justifications.
Indeed, the path to overbought/oversold typically necessitates a positive price-narrative feedback loop wherein building price momentum searches for incremental narrative/fundamental confirmation to further propagate the prevailing (price-narrative) cycle in mutually dependent fashion.
As we highlighted in this morning’s Early Look: US Dollar Exhaustion, the narrative coalescence around the dollar has crescendoed the past few days. I’d encourage you to read that note for the key conclusions as this post largely serves as an addendum to that discussion.
If your process isn’t macro-centric or you don’t (have time to) understand the shifting global Fx narrative, the current dollar storyline principally centers on the following:
- Policy Divergence: Domestic growth and Fed Hawkishness continues to be discounted relative to the prospects in Europe/Japan.
- Repatriation: Large-scale $USD repatriation has been similarly discounted
- Relative Valuation: Relative upside in OUS growth/market valuations
- Fiscal Stimulus: An already widening budget deficit and further prospects for large-scale debt funded stimulus (tax reform, infrastructure, etc)
- Regulation/Credit Creation: Lower regulation, looser credit standards, some corporate capex mojo and the pro-cyclical nature of credit extension drive resurgent private sector credit creation.
- Policy: An explicit weak dollar policy out of the Treasury and renewed Trade War & Protectionism angst.
- Reserve Diversification Angst: The “adjustment to reserve diversification policy” out of China with similar announcements out of Germany and France added to existing dollar and bond bear angst.
We’re not going to argue the veracity of those points or point out that many of them are not new developments (net selling of treasuries by China et al has been ongoing for years), are conspicuously devoid of catalysts (2017 was the posterchild for “valuation is not a catalyst") or are inherently self-limiting (an interminable rise in the Euro or Yen limits the capacity for Draghi or Kuroda to actually hike, rhetorically or actually).
Also bear in mind that the Fed is probably viewing the weaker dollar with, at least, tacit approval. The path of least disruption to asset prices/financial conditions/EM markets in the face of semi-aggressive domestic policy tightening is a weaker dollar.
To recap and add to the conclusions in this morning’s Early Look, here’s where things stand from a market price and sentiment perspective:
- The dollar (finally) = immediate-term oversold from a quantitative perspective
- Euro/Yen/Pound = immediate-term overbought
- Asset prices with strong negative correlations to the dollar are, unsurprisingly, also signaling overbought (Oil, Gold, SPX).
- Derivatives markets are reflecting similar sentiment with risk reversals across the lead currencies having the most bullish tilt of the last 5 years. Indeed, for the GBP, this is the first time in years where the upside is priced more expensively than the downside across the term structure.
Some global dynamics were watching for vis-à-vis the dollar:
- Cyclical – Growth Slowing: We expect the harmonized global growth narrative to splinter as we move through 2018. A growth-slowing shift into Quads 3 & 4 in China and across a broad swath of EM and the EU would contrast with the currently prevailing narrative and buoy (an oversold) dollar.
- Cyclical – Domestic Wage Inflation: A flat Phillips Curves and stubbornly slow labor market and industrial capacity tightening are hallmarks of the current expansion. We are now, however, approaching a point of labor tightness where wage inflation begins to hook higher. Should wage inflationary pressure begin to percolate it should pull policy tightening expectations forward.
- Cyclical-Secular |Policy: While currency gains overwhelming come ahead of the onset of the tightening cycle, historically, there occurs another thrust of appreciation ~1Y before the terminal hike. If the terminal rate is, indeed, significantly lower than it’s been historically that T-1 year mark is not that far out on the timeline given current policy pacing.
- Secular – Demographics: Demographic trends – particularly in the key consumption cohort of 35-54 year olds – over the next 5 years are decidedly more positive domestically vs. the EU/Japan/UK. Over the medium-term, a DM policy rate convergence is not a high probability outcome.
Macro tourism’s evolution into consensus and capitulation is a process, not a point. The dollar isn’t a long (yet) but we wouldn’t be pressing the short here either.
Christian B. Drake
@HedgeyeUSA