Tide turns dollar bullish

Posted on September 26th, 2017

The tide has turned, at least for the moment, for the USD.  It has been on a broadly weaker trend this year, often undermined by political uncertainty in the US.  Stronger global growth has supported EM, and the EUR has rebounded on declining European political uncertainty and a solid European economic recovery.  Lower than expected US inflation outcomes have also put the market in two-minds over the pace of Fed policy tightening. North Korean tension has, if anything, only tended to weaken the USD further, strengthening the JPY, while having little discernable impact on the bullish trend for equities and EM markets.  However, in recent weeks these trends have reversed to some extent.  The market feels a bit full on its exposure to EUR, EM, and equities. 

EM currencies and equities weaker

The chart below shows the performance of emerging market currencies by region against the USD, using equal-weighted indices of 22 emerging market currencies.  There has been a broad-based decline since 7-September, accelerating on Monday, with sharp falls in a number of EM currencies.

In US trading, the iShares MCSI emerging markets ETF fell 1.8% on Monday.  This was perhaps a more classic risk-off response to geopolitical risk, including sabre-rattling by Trump and North Korea’s Foreign minister in New York.

Geopolitical risk has also been given a bit of a lift by the vote on Kurdish independence from Iraq on Monday.  The idea of independence is firmly opposed by neighbouring Turkey and Iraq and may lead to more tension in the region.  Oil prices have surged in response.

Chinese property developer stocks plunged on Monday on reports that eight cities were tightening restrictions on property investment, including banning resales within two to three years of purchase.


Political risk returns in Europe

Political risk has crept back into Europe. The anti-immigration AfD party took a decent slice out of the main-stream party vote in the German election, entering parliament as the third largest party; the first Alt-right nationalist party to do so since the Nazi’s.

Chancellor Merkel still commands the largest party vote and appears to be moving towards a so-called Jamaica Coalition between her centre-right CDU/CSU, the pro-business Free Democrats and the Greens.

Merkel is also dealing with an internal debate over immigration policy with the CSU arm of her CDU/CSU coalition.  The CSU wants a cap on immigration.  This could prove a sticking point in negotiations with the Greens.

It may take some time to negotiate the Jamaica coalition, and the second placed centre-left SPD leader Shultz says he will not agree to another grand coalition if the Jamaica coalition fails to form.

In time, a government led by Merkel may return Germany to relative political stability.  But in the period of negotiations ahead, the market may trade more cautiously towards EUR.


Catalan separatists

Adding to the political uncertainty is more intense pressure for Catalan independence in Spain.  The government is attempting to shut-down a vote on independence scheduled for 1 October.  The long-festering issue is bubbling to the surface again.

German 10-year yields have risen a bit less, and fallen more a bit more than US yields in recent weeks, creating a little more yield support for the USD.


ECB’s Draghi’s dovish taper

ECB President Draghi, in his parliamentary appearance on Monday, re-emphasized the need to be “patient and persistent” with monetary policy and that “a very substantial degree of monetary accommodation is still needed for the upward inflation path to materialise.”

He also reiterated that “the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring with regard to its possible implications for the medium-term outlook for price stability.”


Trump off the rails

Trump and Congress appear to have slid off the rails a bit this week. Trump has diverted attention from tax reform towards pandering to his Alt-right support base by engaging in a tweet storm over NFL players not standing for the national anthem, and threatening NKorea.  Republicans are still trying to repeal Obamacare.  These distractions might undermine the USD again.  The fact that they haven’t is perhaps evidence of a turn in momentum towards a stronger USD for the time being.