More Decoupling: Goldman Continues Bashing The USD, Sees Short-Term Dollar Strength Followed By QE And A Plunge
Goldman's Tom Stolper, in the firm's monthly FX Global Viewpoint, is once again bringing up the theme of a biphasic future in the FX world (and thus, in macro in general), which will see an initial bout of strength for the dollar, which would result in a EURUSD all the way down to 1.22 in 3 months, followed by domestic QE and accentuation of US weakness, which would in turn jettison the dollar, and spike the EURUSD to 1.35 and 1.38 in 6 and 12 months. More importantly, the overarching theme of increasing pessimism and general dread in the writings of Goldman research analysts is becoming ever more palpable, having first originated in the works of the firm's economists, and now shifting to salespeople and product strategists. This in itself would be sufficient to make people believe that Goldman has truly turned bearish, although numerous reports out of the open outcry pit that Goldman's rep repeatedly kept forcing shorts at 1,100 to cover their positions during the day, seems to detract from this particular theory... At least in the short-term.
The six primary reasons for the upcoming decline in the American economy are summarized follows:
US Macro Outlook for the Next 12 Months and Dollar Implications
Combining the new information over the summer with our global growth forecasts, it appears the most likely scenario now is one of ‘pro-cyclical decoupling’ of the US economy from the rest of the world.
As the table shows, we expect the US economy to grow substantially below trend over the next 12 months and in 2011 as a whole. This expected weakness remains directly linked to a number of persistent structural imbalances, which in some cases have started to deteriorate again. In particular, the following points have caught our attention:
- Survey data points to sluggish growth. The latest ISM readings for the manufacturing and nonmanufacturing sector point to continued sluggishness in the respective sectors. Although the latest headline reading in the manufacturing ISM showed marginal improvements, the order-inventory gap and other forward-looking components suggest further sequential slowing lies ahead.
- Persistent high unemployment is a particular feature of the current US problems, hinting at a large output gap. It reflects the need to reallocate considerable economic resources from artificially inflated sectors (in particular, real-estate-related). A shift of a sizeable part of the labour force from one sector to another takes time.
- The US household savings rate remains too low relative to the US’s own long-run history, international comparisons and the demographic situation. As savings rise, the unusually high share of consumption in GDP will likely decline.
- Import demand has picked up strongly during the inventory cycle, highlighting just how little the US economy has rebalanced and how much US demand seems to depend on foreign supply. Relocating production to the US is a slow process.
- Rate differentials have moved sharply against the USD as markets increasingly priced in our own sluggish US growth scenario. Our expectations of renewed Quantitative Easing in the US, following the recent ‘baby step’ of extending the mortgage program, suggest rate differentials are unlikely to boost the USD anytime soon. On the other hand, stronger growth outside the US, in a positive decoupling scenario, would likely weaken the US via a corresponding shift in rated differentials.
- Finally, fiscal consolidation needs in the US are among the most important globally and on many measures, including from the IMF, the adjustment need in the US is comparable to that in the UK, Spain and Greece. Tighter fiscal policy will add to the outlook for slowing final demand in the US, a potentially USDnegative development.
Overall, the US needs to become more competitive to boost the domestic economy relative to the rest of the world. Indeed, the primary channel to gain this extra competitiveness may well be the continued downside pressure on the BBoP, as we discuss in more detail below.
The bottom line in this expected deownward decoupling is that in the
race to the currency bottom, America will once again achieve a head
start, a topic which we are confident will be actively discussed and
affirmed at the next G-8 meeting. Yet, as the dollar will be the sole-beneficiary of any such gradual devaluation, the trade-weighted impact on other currencies will be small, meaning the entire world will suffer as a result of the American (temporary) decline:
By the same token it is equally important that broad USD depreciation against a large number of currencies implies relatively little trade-weighted appreciation of the latter. This is because most countries will see their exchange rate against most key trading partners barely unchanged, precisely because most currencies are expected to strengthen in synch against the Dollar. As a result, we ultimately expect the USD TWI to bear the brunt of the move. The Dollar will therefore likely become notably undervalued relative to our GSDEER model, and this misalignment will help address the structural imbalances discussed above.
Another way of looking at the worsening picture for the dollar, Stolper says, is the deficit of the BBoP: the current account + net FDI + net portfolio inflows.
The current BBoP picture (BBoP = current account + net FDI + net portfolio inflows) is still consistent with persistent Dollar weakness. We estimate the current BoP deficit at around -2.5% of GDP, which continues to be below the -1.5% BBoP deficit threshold that has historically been consistent with USD support. A renewed widening of the trade deficit and a slow recovery in capital inflows are the main factors behind the continued large BBoP deficit.
Meanwhile, although capital inflows in the US have improved over the past year, this has come mainly in Treasury purchases, which we believe says little for the USD outlook relative to floating currencies. The Treasury purchases have largely been driven by the official sector (EM central banks), in accordance with its FX policy objectives and hence mainly a reflection of appreciation pressures for pegged or heavily-managed currencies. Private-sector purchases of USTs are to a large extent probably FX-hedged (owing to the steep US yield curve), thus rendering little FX impact. The same argument can be made for Agency bonds, which have also seen improved inflows recently.
Other areas of capital inflows (equities and corporate bonds) still paint a pretty negative picture—net portfolio flows ex USTs and Agencies (from the monthly TICs data) are still slightly negative, in stark contrast to the +$40bn of so range in the years before the crisis. FDI inflows have been mixed at best, with M&A data pointing to pending moderate US outflows.
Looking ahead, we still find little to signal an impending improvement in the BBoP. The sluggish growth and uncertain fiscal outlook discussed above will likely weigh on US capital inflows and tempt US investors to pursue higher return opportunities abroad. Data from the US mutual fund association, the ICI, confirms that US stocks have been far less attractive than foreign stocks in recent times.
Overall, it will likely take a lot to drive improvements in the US BBoP deficit, given the deep-rooted structural issues discussed above, and this is likely to be a persistent cloud over the Dollar’s medium-term prospects.
And an interesting chart for all the correlation fanatics out there: Goldman plots the inverted EURUSD against PIIGS sovereign spreads, and notices that unlike before, the FX market seems to have habituated to sovereign risk. We would be more cautious here, as it merely means that FX traders are not discounting future risks sufficiently, and certainly not as much as credit traders are. And in the grand scheme of thing, we know which product is almost always proven correct.
EMU sovereign spreads widened again during the risk-averse price action in August. While some of the widening may simply reflect that some debt markets couldn’t keep up with the rally in Bunds, the market is also focusing again on the issues related to debt sustainability and banking stability, and in particular the case of Ireland this time around. There has also been a rerating of growth, which negatively affects long-term debt dynamics. These issues are important for a few of the smaller members of the European Union but overall we think they are largely manageable, and do not offset the positive influence from the ongoing economic strength in the core of Europe. Moreover, the European Financial Stability Facility (EFSF) is now up and running, and provides the previously inexistent backstop that had been at the core of the sovereign crisis earlier this year. Also, interestingly, the EUR has not responded to the spread widening as violently as it has done in the past. In a simple regression framework based on past sensitivities, the EUR should have depreciated more as a response to the recent spread widening.
Bottom line: we agree with Goldman that America is weak and will be increasingly weaker. However, we disagree now, as we did in 2007, that the world can decouple from the US. It can't - China is a mirror of US monetary policy and is the US is a vassal state of the Chinese producer, while domestic consumers are a tolling operation for Chinese products. Which is why a slowdown in the US will certainly drive down China, which in turn will put the brakes on Australia and Brazil, and all the other China second derivative countries. Decoupling is a myth, and thus Europe will likely see much more pain sooner and later. We agree that the near term target is for the EURUSD to drop further, although what happens in 6 and especially 12 months is anyone's guess. One thing is certain - by then the game theoretical cooperation that central banks enjoy now, will most certainly not be taken for granted, as the global economy begins to deteriorated at an ever accelerating pace, and the only marginal buyer is the Fed and its cousins around the world. What the market will look like then is impossible to predict, and certainly not an experiment in which most of today's traders will wish to participate in.