Submitted by Viktor Shvets of Macquarie Research
US$ and its discontents: Liquidity, CA deficits, deflation & EMs
- Are we seeing the beginnings of a much stronger US$? Key investment risk.
- The direction of US$ does not just depend on spreads or even supply of US$ but on whether deflation ultimately proves to be a stronger force.
- We remain deflationists at heart; hence we always worry that US$ might be too strong. However even extreme weakness is deflationary. Watch DXY
There is a distinct possibility of a much stronger USD…
Just when the consensus agreed that the US$ has entered LT bear channel, DXY not surprisingly started to appreciate and, as it passes 92, the question is whether we are likely to witness an intense appreciation. This is the key danger facing investors over the next twelve months.
For many years we have been deflationists at heart and indeed we remain so. Our core beliefs are centred on disinflationary pressures that are likely to get stronger over time. These are driven by a combustible mix of technology (and associated dissolution of labour & product markets) and the impact of three decades of over financialization (and associated over capacity & inability to resurrect conventional pricing signals). In simple terms, investors reside in a world of no wages (or eroding pricing power of labour & products) and the need to keep ‘zombies’ alive to avoid contraction of demand. These forces are highly deflationary and public sectors would struggle to offset them.
In this environment, we should theoretically see that the current anomaly of US$ and gold appreciating at the same time turn into a consistent trend while investors also search for more extreme value alternatives, ranging from fine wines, paintings to cryptos. This investor behaviour might become ever more extreme as the public and electorates demand protection and continuity from CBs & fiscal authorities and politics deliver. It would be positive for US$.
… as the Fed destroys liquidity & extreme positioning unwinds
We believe that investors are already starting to witness weaker supply of US$ (~1%-3% clip, half the rate six months ago, caused by contracting monetary base as the Fed reduces its balance sheet) and seeming inability of the US to significantly widen its CA deficits (despite public sector dissaving).
This shortage is amplified by historically high real spreads.
Hence, we are seeing some unwinding of extreme negative positioning against US$. This might get out of control and it is the intensity rather than simply direction that is critical.
There is another factor that always provides a positive undertone for US$: its role as the global store of value and medium of exchange. A reserve currency must satisfy a number of conditions, which currently only the US$ does. It must have large, liquid and free treasury and FX markets. Neither €, Rmb nor ¥ have these. Reserve currency supplier must also run significant CA deficits to lubricate finance; neither Eurozone, Japan nor China run deficits. Hence, there is always a bid for US$, and only strong reflation or QE could weaken it.
Intense appreciation or depreciation of US$ are deflationary
We maintain that all rapid US$ moves are deflationary. Appreciation works through liquidity and commodity channels to erode growth and make it harder to re-finance US$ foreign debt. However, steep US$ depreciation is equally deflationary as it kills real demand. Hence, neither moves are desirable. Rising US$ is already causing tremors (Argentina, Tukey & Indo); however at this stage these are still moderate.