The bulls are back in control despite the doom and gloom by world leaders at Davos. While the US trades sideways, world markets are firming up. There is a lot to be positive about. The US government is open for business again, and negotiations with the Chinese are set to resume. A hard Brexit is off the table, and the markets are now discounting it as an option.
Exiting the Long USD Trade
After gaining 4% vs. the Euro, we are exiting our long US dollar trade that we first recommended on the 8th of May 2018. This is not to say that we will not have another rally to the recent highs, but we no longer have a strong view for the bullish case.
We are also not convinced of the bearish case until more evidence that the global US dollar debt deleveraging is reversing. With a neutral view, we see US dollar allocations still serving a purpose with yield differentials high enough to offset price declines. For large cash allocations inviting negative interest rates in currencies such as the Euro, it may make sense to utilize the US dollar as a temporary parking space.
One of the primary reasons we were very bullish on the US dollar was the expansion of yield differentials. There was no end in sight when the Fed was broadcasting its intended rate hikes until the markets hit a snag in December of 2018. We are with the markets in pricing in a pause by the Fed until more data comes through on the US economy.
Since we published our US dollar recommendation, the Argentinian Peso was down 39% and the Turkish Lira was down 18% – both after adjusting for interest. The entire Emerging Market complex took a hit during the past year. We now see emerging markets as the primary beneficiaries of a weaker US dollar because of the high debt load denominated in that currency. Emerging market bonds and currencies are already beginning to attract fund flows in anticipation of this changing theme.
Back to the Future
We have long argued that tariffs do not work because adjustments are made through currency channel. Shortly after Trump sparked the trade war, the yuan depreciated 9% vs. the US dollar. It has since recovered 3.5% as negotiations progressed since the tariff cease-fire was announced. So, it did not come as a surprise last week when Mnuchin commented that the Chinese yuan was part of the trade negotiations. The Chinese knew this, and they will continue to use the yuan as a weapon to retaliate against tariffs.
This is not the first time in US history that the US dollar exchange rate becomes a tool for trade negotiations. In the 1980s, Reagan started another trade war with the Japanese, who commanded a large trade surplus against the US. The US was running a current account deficit equivalent to 3.5% of GDP. The negotiations ended in the 1985 Plaza Accord, in which the US, Japan, France, Germany, and the United Kingdom coordinated policy to depreciate the US dollar to correct the trade imbalances that existed at the time.
This effort ended two years later when the Louvre Accord was signed in 1987 to halt the decline of the US dollar. Eventually, the cooperation between these trading partners led to the global trading rules under the World Trade Organization.
It would not surprise us to see a similar commitment made by the Chinese to set the USD/CNH at much lower levels than it trades today as part of a comprehensive trade deal designed to correct the US current account deficit.
Crisis in Caracas
While the population starves, Maduro’s loyal military personnel remain well-fed, but we are nearing the endgame of the Bolivarian Revolution that started under Hugo Chávez. Time is not on Nicolas Maduro’s side. The leader of the opposition, Juan Guaido, moved to create a rival government last week, which was swiftly recognized by the international community as the legitimate representative of the Venezuelan people. Military defections are rising, and refugees continue to flee to neighboring Latin American countries to join more than 3 million Venezuelans that have already left since Chavez was first elected. To put these numbers into perspective, the population of Venezuela is 32 million.
Venezuelan oil exports are primarily shipped to the US refineries on the Gulf Coast and distributed through the Venezuelan-owned CITGO. The political confrontation which may end up in armed conflict or a full-on oil embargo will be primarily absorbed by US consumers. The larger impact will be the humanitarian crisis that will accelerate the outflow of Venezuelan refugees into Latin America. With China and Russia blocking action at the UN Security Council, the more likely outcome is a civil war between the competing political factions.
The Week Ahead
The Fed will decide on its Fed Funds Rate on Wednesday, and we expect no change from the previous period. Markets are already pricing in a pause.
Eurozone countries are delivering GDP data this week. We should get a pretty good idea on how much weaker the Eurozone economy is to warrant the ECB’s dovish view. US GDP growth is also expected to drop from the 3.4% level to 2.6% to reflect the slowdown already witnessed in leading economic indicators. Canada’s GDP data will likely show a contraction in Q4.
German and French inflation data is of note, as it will ease German fears about the continued monetary accommodation. Perhaps the better policy would be to prompt the Europeans to loosen the strict budget deficit limits that choke growth and fuel the rise of populist movements throughout Europe.
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