USD Dynamics in 2020

by Gauravjit Singh, Singapore

2020 has been a roller coaster ride so far, and riding the markets has not been easy for the faint hearted. Global economies are facing a negative growth shock that will likely reverberate for a few years, and consumer trends may change for even longer. Yet equity markets have shrugged off everything that has been thrown at them. At the core of it, the unprecedented shock and awe response from the Fed and other global central banks has trumped every other factor.

After the dust began to settle following the March panic, the view that has worked has been a reflationary one, which is by no means a consensus: Steeper rate curves, higher equities, sharp rebound in credit indices, short USD, and a gradual drift higher in commodities. Essentially, the rising tide of easy money has lifted all boats.

To judge where FX markets head next, I find it key to understand why the USD bounced higher in June. A better sense of these factors can help in preparing for the next move, which in my view is eventually down. However, given the awesome straight line run down we experienced in May, it is highly likely that the next part of this downtrend will require patience and agility. While data has been picking up quicker than anticipated, serious concerns remain about second waves of Covid globally as economies reopen. Add geopolitical factors such as China flexing its muscles over HK and we have a potential tinderbox ahead. Let us explore some factors that impacted the USD in June:

1). POSITIONING

Most indicators of short term market positioning such as IMM data suggested that USD shorts had built up aggressively towards the late stages of the move in early June. However, from a long term structural perspective, the market remains very overweight US assets and the USD. A lot of European pension money in US assets remains unhedged. Jan-Feb saw a surge in reverse Yankee bond issuance that was unhedged as well (US corporates issuing European bonds and swapping the proceeds back into USD). This “real money” imbalance will slowly have to be corrected.

Further, anecdotally cash piles are high and while equities have seen record rallies, most surveys suggest that investors remain bearish risk. Retail has been a big driver no doubt with the Robinhood crowd piling into any stocks they could get their hands on, even the companies that filed for bankruptcy (look at Hertz!). Retail positioning is far heavier than institutional positioning. In the end I would say the market is less prepared for a risk rally (typically USD bearish in this environment) and is probably biased towards a classic August wobble (which would typically be seen with a USD bounce) and may get caught off side.

2). PRICE ACTION

Long term levels supporting EURUSD and capping the USD-Index are still in place this year. As soon as the March panic stabilised, the USD downtrend took hold with strong momentum. But throughout the month of June, that momentum became stretched to record levels in several G10 pairs such as EURUSD, AUDUSD and NZDUSD. Nothing goes in a straight line forever and it is now a question of looking for the next short term signals.

3). FED vs US TREASURY

While September FOMC is increasingly gaining importance, with the market expecting additional support and perhaps yield curve control, it is important to realize how effective their actions have been so far. In fact, the “whack-a-mole” approach to markets was so effective that the Fed has slowly started to roll back some of their measures. Central to these measures were FX swap arrangements offered to global central banks that dealt with the USD funding stresses earlier this year. Now, as we start the third quarter, there are fresh questions regarding what may seem to be a perplexing picture of Fed’s balance sheet since it did NOT expand in June but instead saw a mild contraction…

The Fed’s balance sheet dropped by almost $160bn over the month of June, from its peak at the end of May. No surprise then that with this driver of USD weakness missing last month, moves down in the USD ran out of steam. Keep an eye on how this evolves in the second half of the year.

Equally impressive has been the quick consensus across governments to provide fiscal support. Even the EU, with all its detractors, is on the verge of reaching a consensus on an unprecedented stability fund which will be debated by the The Council on 17 July. While the checks fly out in the US (some to people who had already died!), there is one big issue that needs to be better understood. The US Treasury issuance has been at a far larger pace than the Fed is buying assets. The Treasury General Account at the Fed sits at an all-time high of $1.722 trn. This is thanks to the massive frontloading of issuance over the last quarter.

To try to put this simply, the Treasury has issued the bonds, raised the money, and held a large amount in cash. At the same time in June, the Fed has slowed down how much of those issued bonds it is buying.

The fact that this cash pile is outpacing the Fed’s QE asset purchases, suggests that we are in fact seeing a net withdrawal of USD liquidity from the system. In effect, the true impact of the Fed’s QE has been dampened to this extent. Again, no surprise therefore that the USD move down began to run out of steam in June.

The Treasury’s position may not be entirely clear – Perhaps this war chest has been built as a buffer to account for uncertainty in timing of outflows to pay for all the fiscal programmes. Their quarter end target for the cash balance was around $800bn, so they are currently double that with no signs of reversing (a reversal in this cash balance makes its way into the market via an increase in excess reserves with commercial banks). However, considering the Q3 issuance calendar seems to have been pared down considerably, the Fed may finally get an opportunity to begin out printing the Treasury again. I would keep a close eye on this dynamic also because this is absolutely key to a “USD debasement” theme.

4). YIELDS

This has probably been one of the bigger drivers of the USD decline so far, if you buy-in to the above point that the Fed’s QE impact has not even started to properly hit markets. And more relevant than the drop in nominal yields is the sharp drop in real yields. Real yield differentials are more relevant the closer we get to the zero bound. Expectations of a V-shaped recovery have boosted inflation expectations and breakevens, driving real yields lower. This is relevant as the US recovery (however fragile it is amid the second wave of infections) is more reflationary in nature than the recoveries in Europe.

And while we can question what the shape of the recovery really is, there is no denying how hot the data is coming in relative to expectations. US economic data surprise indices are at all-time highs, perhaps a sign of how downbeat expectations got. Note that research also suggests that sharp rises in these indices are often accompanied by a lower USD.

Overall, I think there is ample reasoning to suggest why the USD move has stalled over the course of June. However this all appears temporary – there is adequate evidence to suggest that broad underlying themes remain intact, while I have tried to identify key drivers and metrics that need to be watched for signs of a renewed trend decline in the USD. It may take it’s time, but decline it should. Amid all this, we must navigate the virus, US-China relations, US earnings season, other geopolitical flareups, and of course the US election. On that final point, here is a chart of the USD Index (red) vs Trump approval ratings (black).

Gauravjit Singh has worked in Foreign Exchange Hedge Fund sales for over 14 years covering the largest and most sophisticated clients across the globe.

SKA