There is a new game, afoot. For the last couple of years, it has been about normalizing policy. Even the Bank of Japan, which has never declared it was tapering, has gradually reduced the amount of government bonds it purchases. Countries like the U.S., or Canada in 2017, who could raise interest rates were rewarded with stronger currencies. The tide has turned. The maturing business cycles may have been rolling over before they were pushed by the direct and indirect costs of the two largest economies pursuing import substitution strategies simultaneously. Canada and Norway may be in a better relative position to weather the coming storm. Neither is under any pressure to provide more stimulus. Norway is more inclined to hike rates and record jobs growth in Canada will keep the central bank on neutral.
Slowing growth and economic nationalism spooked global investors and businesses in Q4 18. The tariff truce negotiated between the world's two largest economies and better data helped lift the animal spirits in Q1 19. Growth in the U.S., EU, Japan, and China surprised on the upside. However, the growth seemed to perversely discourage reform and was seen as often as an "all clear" sign to resume the trade conflict.
As Q2 19 winds down, world growth has slowed, and trade conflict has been reanimated. It turns out, central banks were not the only buyers out there for government bonds. Record low yields are being experienced in many countries, and there are around $11 trillion of negative yielding bonds in Europe and Asia, an increase of more than 30% since the end of last year.
Trade and growth are tied together but not merely because of the net export function of GDP. When all is said and done, the U.S. is a relatively closed economy—exports plus imports are a little more than a quarter of GDP. This is lower than all but seven countries, according to the World Bank. The more critical and urgent link between trade and growth is that the U.S. tariffs are tantamount to a tax hike that, under conservative assumptions, offset the tax cuts for the vast majority of American households.
It may take some time for consumers to take much notice, but it is cumulative, and as the tariffs on China broaden to include more consumer goods, and the tariff rate on $200b bln of imports more than doubled to 25%. U.S. retail sales are expected to have bounced back strongly in May after a 0.2% fall in April. We already know that auto sales recovered in May. Investors may not be forgiving if the new data on consumption disappoints, especially after the poor jobs report.
At the same time that U.S. fiscal policy is shifting to a less stimulus stance, the risks are rising that monetary policy will become more accommodative. The sustained inversion of the 3-M:10-Y U.S. curve is a tough benchmark to fade for investors and businesses. The strength of the labor market has been a critical anchor of the economy and the Fed's reaction function.
The disappointing May jobs growth, the second such downside shock in four months, coupled with the downward revisions, and softer earnings growth, and no bounce-back in the work week, and the inverted curve command attention. Following the jobs report, one large U.S. money center bank adopted as its base case a 50 bp cut by the Fed in September and a follow-up cut in December. It said a 25 bp cut in July was also possible. The January 2020 fed funds futures contract implies an effective average rate of 1.675%. It is currently 2.37%—implying the better part of three cuts has been discounted.
The policy mix of tighter monetary policy and looser fiscal policy provides a steroid-like boost to currencies. This is what the U.S. had under Reagan-Volcker. It is was the policy mix in Germany after the Berlin Wall fell that led to the ERM crisis of the early 1990s and then Maastricht Treaty and the euro. It helped fuel the dollar's gains last year. Now that policy mix is reversing. Fiscal policy is tightening, and monetary policy is poised to loosen. That policy mix is associated with under-performing currencies.
The third significant dollar rally since the end of Bretton Woods is in jeopardy. Coordinated intervention marked the end of both the Reagan-Volcker and Clinton-Rubin dollar rallies. Intervention in the foreign exchange market won't be necessary; the self-proclaimed "Tariff Man" has found another way the proverbial cat can be skinned.
The last phase of a significant dollar rally has been marked by the movement of interest rate differentials against the U.S. This has been happening. The two-year differential between the U.S. and Germany peaked last November a little above 355 bp, which appears to be a modern extreme. It finished last week below 250 bp, the lowest in more than a year. Similarly, the U.S. two-year premium peaked against the UK around the same time, a little shy of 220 bp. It is now approaching 125 bp. Against Japan, last November, the U.S. two-year premium of nearly 310 bp was the largest in 11 years. It is threatening to break below 200 bp.
The peak against Canada was more recent. It topped near 85 bp in February, which was most since the Great Financial Crisis. It is now below 45 bp for the first time in a little more than a year. The market is pricing in aggressive easing by the Reserve Bank of Australia, but the U.S. two-year premium vs Australia has fallen 30 basis points over the past two weeks to less than 75 bp.
It has become common for observers to moan about the "exorbitant privilege" that the U.S. enjoys, parroting the more than half a century ago claim by a French finance minister. But what does that mean when the U.S. is currently paying about 1.83% to borrow its own currency for two years when Spain and Portugal can borrow for two years at a negative rate but no printing press?
In addition to the changing policy mix and narrowing interest rate differentials, consider valuation. The euro is currently about 23% under-valued by the OECD's purchasing power parity model. In late 2016/early 2017, it was under-valued by a little more, but OECD currencies typically do not deviate much more than beyond 20 % from the OECD's model of PPP. It is also important because the euro is for most practical purposes the go-to alternative to the dollar. Sterling is nearly 14.5% under-valued. It had been almost 18% under-valued at the end of 2016. The yen is almost 8.5% under-valued. In 2015-2016, the yen was 20% under-valued.
This three-prong case for the end of the third significant dollar rally since the end of Bretton Woods does not mean that the dollar is about to collapse. The interest rate differentials, though narrow, are still wide. Moreover, it is not like the divergence has been closing not because other countries have stepped up, but because the U.S. business cycle is rolling over and the fiscal tailwind has become a headwind. Foreign exchange remains an ugly contest rather than a beauty contest, and the U.S. appears to be intent on shooting itself in the foot.
While Chinese markets were closed before the weekend, PBOC Governor Yi Gang seemed to wave a red flag in front of the dollar bulls that want to test the CNY7.0 level. Yi said two things of note. First, he said he was not compelled to defend any particular level. Second, he indicated, like Draghi did the day before, that there are numerous policy tools available to support the economy if necessary. We suspect the Governor was not talking the yuan down but was part of the endorsement that markets should determine exchange rates (in an ideal world).
The onshore yuan was unavailable and more restricted in any event, the offshore yuan was sold to a new low since last November with the dollar pushing above CNH6.96. The poor jobs data saw the dollar pullback and given its broad losses ahead of the weekend, it may help deter a run at CNY7.0. Both Yi and Mnuchin who will meet on the sidelines of the G20 meeting present the liberal, as in liberty and market-oriented, wings of their respective governments, which, not to put too fine a point on it, do not appear to be in ascendency.