Submitted by Michael Every of Rabobank
There are lots of theories about what factors drives FX markets: interest rate differentials; real interest rate differentials; central bank actions like QE; real effective exchange rates; ‘fair value’; the fiscal deficit; the current account deficit; capital flows; speculation; sentiment; and technicals. (Add your own if I missed one.) Of course, none of these factors alone ever tells you where a currency is actually going to trade on any given day, and the precise combination of the above that might shifts all the time from currency to currency (almost as if they aren’t actually explanatory at all…)
Think of the USD. Can you think of a currency less deserving of its current strength? True, rates are at 2.50%, but the market is now expecting two cuts this year, and our Fed watcher Philip Marey is talking about five cuts once the Fed gets moving. Think about the vast and rising US fiscal deficit and public-sector debt, and then about the sizeable trade and current-account deficits it always runs. Consider the trade war, which should–in the eyes of some–be choking off capital inflows that hold the USD up. Yet a strong USD, especially vs. EM, continues to be seen this year, as we had expected, and as we continue to expect. That’s true even if we broaden our range of indicators out to consider that US hegemony and USD reserve status perhaps aren’t what they used to be, with ever-more speculation that the day of the Dollar is over.
Yeah, right! While the US’ relative economic, financial, and military strength is obviously less than it once was, the power it still wields through being a vast final demand market for most of the world’s exporters, and through the fundamental financial architecture of the US Dollar system, is enormous. Three news items in the last 24 hours, alongside this year’s trend to date, underline that bullish USD view.
- First, we have the US showing Europe who is boss vis-à-vis Iran. Recall that several European states had set up a Special Purpose Vehicle called INSTEX specifically to continue trading with Iran, which is under biting US sanctions, without using either USD or the US SWIFT network. In short, from Washington’s perspective parts of the EU are aiming to deliberately evade US sanctions because they feel it’s more important to sell things to Iran, and buy its oil, than to listen to warnings from the country that provides their main security that Tehran is still trying to build a nuclear weapon that would threaten everyone. So what has the US response been? Predictably, crushing: according to Bloomberg, the US is warning Europe that anyone and everyone involved in using or running INSTEX could be barred from the US financial system if it goes into full operation. Doesn’t that sound like Seinfeld’s Soup Nazi? Only in this case it’s “No Dollars for you!”
- Second, we have the story in the South China Morning Post that even a former PBOC advisor Yu Yongding was refused permission to transfer USD20,000 from his own personal account abroad, being told by the teller that he was “too old”. (He’s 65, which one would think is still time enough to spend that much cash.) Again, that sounds like a Dollar Nazi: “No Dollars for you!” Of course, on paper everyone in China can withdraw USD50,000 a year. In reality, nobody can, which sits a little oddly with a purported global reserve currency; indeed, that’s one of the reasons why CNY still actually isn’t one and won’t be one for a very, very long time yet. Why is access to USD being so restrained when China is winning this trade war so comprehensively? Because the underlying reality is that without capital controls, CNY and the financial system would collapse. Furthermore, as I have been repeating for years, the vast expansion in CNY debt is not being matched by an increase in USD, meaning ever fewer people would need to shift just a portion of their savings into USD for the “3 trillion” in FX reserves China somehow magically always has to just disappear. Plus, of course, the trade war makes matters exponentially worse; as I also keep repeating, if China can’t earn USD from the US, this whole paradigm collapses.
- Which brings us to our third news item: the same Yu Yongding above speaking at a state think tank is reported as saying on USD/CNY “There’s no big difference between 6.9, 7.1, 7.2…we’ve just been scaring ourselves,” and that there won’t be a problem if CNY goes past 7. Of course, he’s right. There are no combination of fundamentals that say 6.99 is fine and 7.01 is disaster. Yet a much weaker CNY looms eventually when one looks at one of the key factors that all the FX analysis I started with generally ignores: the politics of the fact that this remains a USD world, and we just live in it. If you don’t behave, it is still a case of “No Dollars for you!”
Yes, eventually that aggressive US stance could see the Dollar pushed aside. But the spectrum of power that any replacement would need to provide, and the rapidity with which everyone would have to make the move to generate a network effect, tells me it’s not going to be anything to trade on just yet. Even more so when we see: global manufacturing PMIs stumbling; China slowing; most Asian exports slumping; German unemployment suddenly leaping; Italy about to face a huge fine for widening its budget deficit, bringing the risk of a new Euro crisis; Boris Johnson in court for allegedly lying over Brexit (a precedent that should make all politicians, and not a few journalists, very, very nervous); and the market talking about four rate cuts in Australia (catching up with my own thinking), even if AUD isn’t following for some reason.
When the whole house is falling down, you go to the safe room: and that’s still the US (and CHF and JPY) even if the US is the once shaking the house’s foundations.