The world’s largest market isn’t buying the feel-good narrative that investors have embraced this week with global stocks sitting on the cusp of setting a record high and the riskiest corporate bonds soaring like the world economy is back in synchronized growth mode. But traders in the $5 trillion-a-day foreign-exchange market are flocking to the dollar, yen and Swiss franc, which is a bit odd since those “haven” currencies normally outperform when the outlook is worsening, not improving.
Of course, exchange rates are driven by a seemingly infinite number of variables, but it’s notable that the dollar, yen and franc are the best performers over the past week against a basket of developed-market currencies. The dollar measure is the highest since 2017, while the yen gauge is rising the most since the late 2018 turmoil in global markets. That’s even with speculation rising that the Federal Reserve may need cut interest rates later this year as inflation slows and the Bank of Japan saying on Thursday that it has no intention of raising rates for at least 12 months. It’s not hard to see what has currency traders on the defensive. More and more central banks are expressing concern about the global economic outlook and slower inflation, with the Bank of Canada and Sweden’s Riksbankjoining the chorus this week. South Korea, a bellwether for global trade and technology, cast doubt over hopes for a quick rebound in the world economy by reporting on Thursday its biggest contraction of gross domestic product in a decade. China is sending signals that that it might dial back economic support measures, which is a bit concerning given that 3M Co. and Caterpillar Inc. both warned this week about weakening business conditions in the Asian nation. Throw in a budding currency crisis in both Turkey and Argentina, and it’s understandable that foreign-exchange traders might not be ready to join the party.
Ominous Sign
Both the dollar and the yen are rallying in a sign FX traders are getting concerned
Source: Bloomberg
Perhaps there’s no better indicator that all is not well than global trade. New data on Thursday show volumes are falling at t he fastest pace since the depths of the financial crisis, according to Bloomberg News’s Fergal O’Brien. Calculations by Bloomberg based on the Dutch statistics office’s trade monitor show a 1.9 percent drop in the three months through February compared with the previous three months. That marks the steepest drop since the period through May 2009. Comparing the most recent three months with a year earlier is similarly disappointing. That measure saw a second consecutive decline, also the biggest since 2009.
EMERGING MARKETS TAKE A HIT
The most concerning thing about the currency market is the strength of the dollar, at least as it relates to emerging markets. That’s because every time the greenback makes a sustained move higher, investors get worried borrowers in emerging markets will have a tougher time servicing the trillions in dollar-denominated debt they have taken out in recent years. So it’s little wonder that the MSCI Emerging Markets Index of equities fell as much as 1.15 percent Thursday in its biggest decline since early March. An MSCI index of EM currencies fell the most since early December. Recent history shows such knee-jerk reactions aren’t warranted. Emerging markets weathered a much stronger dollar just fine in 2014, 2016 and 2017. These economies largely restructured their economies after the financial crisis, and much of their trade revenue is in dollars, which actually makes it easier to pay back their dollar-denominated debts. Foreign-exchange reserves for the 12 largest emerging-market economies excluding China have jumped to $3.22 trillion from less than $2 trillion in 2009, data compiled by Bloomberg show. But with global trade slowing, the trend could begin to reverse. For now, though, the bond market seems sanguine. The extra yield investors demand to own emerging-market bonds instead of U.S. Treasuries stands at about 2.88 percentage points, little changed over the past three months and far below the 3.50 percentage point level reached in early January, as measured by the Bloomberg Barclays EM Hard Currency Aggregate Index.
The most concerning thing about the currency market is the strength of the dollar, at least as it relates to emerging markets. That’s because every time the greenback makes a sustained move higher, investors get worried borrowers in emerging markets will have a tougher time servicing the trillions in dollar-denominated debt they have taken out in recent years. So it’s little wonder that the MSCI Emerging Markets Index of equities fell as much as 1.15 percent Thursday in its biggest decline since early March. An MSCI index of EM currencies fell the most since early December. Recent history shows such knee-jerk reactions aren’t warranted. Emerging markets weathered a much stronger dollar just fine in 2014, 2016 and 2017. These economies largely restructured their economies after the financial crisis, and much of their trade revenue is in dollars, which actually makes it easier to pay back their dollar-denominated debts. Foreign-exchange reserves for the 12 largest emerging-market economies excluding China have jumped to $3.22 trillion from less than $2 trillion in 2009, data compiled by Bloomberg show. But with global trade slowing, the trend could begin to reverse. For now, though, the bond market seems sanguine. The extra yield investors demand to own emerging-market bonds instead of U.S. Treasuries stands at about 2.88 percentage points, little changed over the past three months and far below the 3.50 percentage point level reached in early January, as measured by the Bloomberg Barclays EM Hard Currency Aggregate Index.
Under Pressure
The rising dollar is starting to weigh on emerging-market assets
Source: Bloomberg
WILL HISTORY REPEAT?
What’s truly extraordinary about the dollar’s renewed strength is that it comes with the futures market moving back toward pricing in a full quarter-point Fed rate cut this year amid speculation the central bank will want to keep inflation from slowing too much and damaging the economic recovery. Lower rates are supposed to damp demand for a currency. There’s no shortage of market participants betting on a repeat of 1998, when the central bank pre-emptively lowered rates to keep events abroad from damaging the U.S. economy, according to Bloomberg News’s Vivien Lou Chen, even though the S&P 500 was rallying and growth was stable. Atr the time, markets were dealing with the Asian financial crisis, Russia’s debt default and the near-collapse of hedge fund Long-Term Capital Management. “You have to pay respect to what the market is pricing in,” Brett Wander, who oversees $28.7 billion as chief investment officer for fixed income at Charles Schwab Investment Management, told Bloomberg News. “A rate cut is a scenario that people have got to consider, even if it’s not the most likely scenario.” Even with markets pricing in a potential Fed rate cut, money markets are still working in the dollar’s favor. Short-term interest rates — which determine the price of currency futures contracts, or forwards — are much higher in the U.S. than in Europe and Japan, according to Bloomberg News’s Katherine Greifeld. The three-month London interbank offered rate in dollars is 2.58 percent, almost 300 basis points above the comparable rate for euros. The difference has almost doubled in the past two years, raising the cost of shorting the greenback for fund managers, Greifeld notes.
What’s truly extraordinary about the dollar’s renewed strength is that it comes with the futures market moving back toward pricing in a full quarter-point Fed rate cut this year amid speculation the central bank will want to keep inflation from slowing too much and damaging the economic recovery. Lower rates are supposed to damp demand for a currency. There’s no shortage of market participants betting on a repeat of 1998, when the central bank pre-emptively lowered rates to keep events abroad from damaging the U.S. economy, according to Bloomberg News’s Vivien Lou Chen, even though the S&P 500 was rallying and growth was stable. Atr the time, markets were dealing with the Asian financial crisis, Russia’s debt default and the near-collapse of hedge fund Long-Term Capital Management. “You have to pay respect to what the market is pricing in,” Brett Wander, who oversees $28.7 billion as chief investment officer for fixed income at Charles Schwab Investment Management, told Bloomberg News. “A rate cut is a scenario that people have got to consider, even if it’s not the most likely scenario.” Even with markets pricing in a potential Fed rate cut, money markets are still working in the dollar’s favor. Short-term interest rates — which determine the price of currency futures contracts, or forwards — are much higher in the U.S. than in Europe and Japan, according to Bloomberg News’s Katherine Greifeld. The three-month London interbank offered rate in dollars is 2.58 percent, almost 300 basis points above the comparable rate for euros. The difference has almost doubled in the past two years, raising the cost of shorting the greenback for fund managers, Greifeld notes.
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