The February 2018 post, Keep your eye on the dollar as an indicator of risk sentiment, warned that the greenback's path should be closely monitored given that it has been a key determinant of returns on risk assets for nearly 20 years. This has particularly been the case for foreign securities and currencies. The USD has since gone on to make a six month high in May for the first time following its 2017 top. Predictably, doom and gloom concerning the prospects for risk assets, currencies, and growth outside of the US has ensued. This facet was touched upon in the subsequent May post The Bull & Bear Case for Risk Assets.
1.) The SPX made a new all-time high after seven months of consolidation.
2.) Long term treasury yields remain close to multi-year highs as US NGDP growth is now the fastest it's been this cycle.
3.) US credit spreads have not followed the rise in the dollar.
4.) Global credit spreads are nowhere near panic stages.
As for foreign currencies and assets, both will very likely underperform their US counterparts until the USD begins to weaken materially. Whether the USD's rise is the cause, effect, or a symptom of potential troubles in the rest of the world, market participants have a tendency to bid down the currencies, equities, and bonds/debts of foreign economies whenever the greenback trends higher. This is particularly the case for economies that either are the most leveraged in dollars (a high degree of dollar denominated debt), run large current account deficits, and/or have the worst reserve positions. In essence, these countries are "short" dollars at precisely the wrong time. Therefore, it should come as no surprise that news stories about financial turmoil in foreign economies tend to break following a persistent bout of dollar appreciation.Despite Turkey, Argentina, or China fears amid the dollar's current strength, there are still enough positives to suggest that the present trend in the dollar may still be nothing more than a counter-trend move in a multi-year sideways consolidation. Should the greenback falter in the months ahead, this would undoubtedly be a positive for risk taking. This post seeks to explore this possibility. With that said, until it breaks below support, the dollar's present strength will be given the benefit of the doubt for the time being.
1.) The SPX made a new all-time high after seven months of consolidation.
- After seven months of back and forth trading, the line of least resistance in the S&P 500 appears to be higher. Moreover, the breakout to new highs came just as the dollar index declined for 2-3 weeks in a row.
- Although persistent dollar appreciation has been a good indication of risk aversion, new-highs after a politically charged first half of 2018 does not signal that global market participants have turned overly negative.
- It goes without saying that this combination still favors US risk assets over their EM counterparts and should remain so until the dollar trend reverses.
2.) Long term treasury yields remain close to multi-year highs as US NGDP growth is now the fastest it's been this cycle.
- Much like US equities, long term treasury yields have held up well thus far confirming the present strength in US NGDP growth.
- In fact, the year-over-year pace of US nominal GDP growth has surpassed the 5% barrier for only the third time since the GFC with a Q2 2018 reading of 5.44%.
- Unless both of these trends reverse, it is difficult to be overly pessimistic. Therefore, it's likely that further dollar strength would require greater fear among investors that US growth could disappoint in the second half of 2018 and beyond.
3.) US credit spreads have not followed the rise in the dollar.
- Much like the dollar, credit spreads are a great way of determining the risk taking attitude of market participants at any given moment. In times of panic or rising negativity, it's only natural for riskier bonds to fall in price relative to safe ones. This manifests itself in declining long term treasury yields as high yield rates move higher.
- Today, high yield bond spreads remain as tight as they have been since the 2015-2016 China scare when they surged by over 220% in the 18 months following July 2014.
- Much like new-highs in US equities, tight credit spreads are inconsistent with overly negative expectations going forward. In order for the dollar to break above its current multi-year period of sideways trading (2014-present), it would very likely require that spreads wide materially.
4.) Global credit spreads are nowhere near panic stages.
- Similarly to their US counterparts, emerging market credit spreads (BofAML EM corporate plus option-adjusted spread) have also typically mimicked the USD. Both tend to rise during panics and recessions while they decline during recoveries.
- The 2001 recession saw the EM corporate spread wide to above 6% before collapsing to 1.45% by March of 2006. During that period, the trade weighted dollar index corrected by over 30%.
- Importantly, EM spreads widened before the dollar bottomed in the lead up to the 2008-2009 Global Finance Crisis. By March 2008, the dollar had only just hit a major low whereas the EM spread had already moved back above 4.5%. The latter would go on to widen to nearly 14% during the height of the panic as the dollar rocketed by roughly 25% in less than a year.
- The turbulent post-GFC recovery saw the EM spread flair up above 5% on two separate occasions due to the 2011 Eurozone debt crisis and the 2016 China fears. These back-to-back episodes also helped usher in a mult-year appreciation that saw the major trade weighed USD index rise by 40%.
- By the beginning of February 2018, both the dollar and EM spreads had made relative lows before moving higher. However, whether one looks at Latin America, EMEA (Europe, Middle East, Africa), or Asia, these spreads are nowhere levels that have been consistent with past panics. This would suggest that excessively worrying about the state of the world outside of the US is unwarranted at the moment. Unless EM spreads continue to widen materially, the current financial news cycle is very likely overblowing the risks to global growth emanating from abroad.
Concluding Remarks:
The dollar has made a six month high after nearly two years of not doing so and predictably EM spreads have followed it higher. Fortunately, the latter haven't widened anywhere near panic levels despite counterproductive trade rhetoric and capital outflows. Still, attention should be paid to this relationship to see if they keep trending higher together.
The dollar has made a six month high after nearly two years of not doing so and predictably EM spreads have followed it higher. Fortunately, the latter haven't widened anywhere near panic levels despite counterproductive trade rhetoric and capital outflows. Still, attention should be paid to this relationship to see if they keep trending higher together.
As for the US, equity indices have just made new highs after seven months of consolidation. While equities paused for the first half of 2018, corporate profits and NGDP have both surpassed cyclical highs. Although 10-year treasury yield has struggled to remain above 3%, positive growth expectations have kept them from declining. All of this along with tight US high yield credit spreads should give global investors reasons to favor the possibility of positive outcomes going forward over negative ones.
With all that said, the dollar is still in a multi-month uptrend in the context of a four year sideways consolidation. As long as this continues, EM should keep underperforming US assets. If the greenback were to head toward its 2017 top then more caution will be justified. That remains to be seen, but that potential scenario can't be ignored either.
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