What happens when tide goes out on dollar?

An opinion piece by Bloomberg argues that the big summer rally in the greenback may have run its course. The Fed’s fight against inflation could benefit, but look for disruption elsewhere. Caliber.Az reprints this article. 

There comes a time when the most reliable of trends has reached the point of exhaustion. It’s just possible that point is about to come for the US dollar. But that in turn just might egg on the steady rise in bond yields.

By any sensible measure, the dollar has staged an impressive rally over the summer — all the more so as other central banks have been seen as more likely to hike rates in future. Bloomberg’s dollar index, which includes both developed and emerging currencies, is at a high for the year and has broken above its long-term trend. That runs against widespread expectation.

This may be sustainable for the US, and helps the Federal Reserve’s fight against inflation by making imports cheaper in dollar terms. But it’s a problem for others. On a trade-weighted basis, the Japanese yen is now its weakest this century. Japan intervened to prop up the yen almost a year ago; the currency is even softer now.

Are we at the point where the Bank of Japan feels compelled to intervene? Quite possibly. Masato Kanda, Japan’s vice finance minister for international affairs, said on September 6 that “if these moves continue, the government will deal with them appropriately without ruling out any options.” Japan-watchers describe this as a clear warning that intervention is imminent.

Away from the Finance Ministry, the pressure on the central bank to keep 10-year yields down can only intensify. After holding them at zero for years, its latest liberalization of yield curve control, or YCC, has brought a new level of 0.65 per cent. But core inflation has suddenly shot up to more than 4 per cent. There have been false alarms aplenty in the years since Japan’s asset bubble burst in 1990, but this really begins to look like the end of “Japanification” — a prolonged deflationary period of slow growth. If that’s true, 10-year yields look unsustainably low.

Therefore, the risk that the dollar’s strength provokes a response from Japan looks considerable. Added to this, China — as discussed in Points of Return yesterday — is also reaching a point where it could feel forced to intervene. Any moves by either would likely have the consequences of pushing the dollar down and putting more pressure on US rates to rise further.

Even though the yen remains weak against the dollar, carry trades — the policy of borrowing in yen at dirt-cheap Japanese interest rates and parking it in a higher-yielding currency, often in Latin America — are beginning to suffer. One of the most counterintuitive trades of recent years has been to pile into the Mexican peso.

The country is conservatively run (even under left-wing President Andres Manuel Lopez Obrador), and so is unlikely to run into fiscal difficulties, while it has maintained anti-inflationary orthodoxy by raising rates repeatedly. Mexico also benefits very directly from economic growth across the border. For all its problems, Mexico has thus been a great destination for carry traders, who have more than doubled their money over the last two years.

However, this week, the peso has reversed sharply against both the yen and the dollar. Upward trends remain in place, but the sudden move to take money off the table in Mexico, with heavy sales of the country’s bonds, could warn that some of the stranger trends in foreign exchange are about to crack.

Any moves by other countries to strengthen their currencies would likely push US bond yields, which continue to threaten their highest levels in decades, still higher. And that leads to the question of just why bond yields are so strong...

“It’s called beige for a reason,” intoned JPMorgan’s David Kelly on Bloomberg TV after the Fed’s Beige Book was published. “It’s usually very much a consensus read of economic data.”

That’s fair enough. A collation of observations from all the Fed’s regional branches, the Beige Book is deliberately impressionistic and strives for balance. It shouldn’t generally have much market impact. The latest edition might be an exception, however, because at the margin it seemed to support the notion that US rates should be lower, just as the market continued a concerted push higher.

Perhaps the single most important line is this one, which appears right at the beginning of the 32-page document.

Consumer spending on tourism was stronger than expected… But other retail spending continued to slow, especially on non-essential items. Some Districts highlighted reports suggesting consumers may have exhausted their savings and are relying more on borrowing to support spending.

The implication for the Federal Open Market Committee is that there is less need to raise rates further. One of the most persuasive explanations for the very long lag between the tighter money to date and any clear economic consequences has been that consumers were still flush with cash. If that’s finally over, it implies conditions could at last begin to tighten in earnest.

Further reasons for dovishness were also there for those who looked. Corporate profit margins are an important driver of inflation. If companies can maintain their markups over the costs they pay, then their profits are unscathed and prices will go up. And yet it seems that companies can’t sustain them. This is how it was put, in beige.

Contacts in several Districts indicated input price growth slowed less than selling prices, as businesses struggled to pass along cost pressures. As a result, profit margins reportedly fell in several Districts.

And if capital isn’t pushing up inflation, it appears that labour isn’t so malign either. The presiding view is that “the second half of the year will be different” following surprisingly high pressure for higher wages in the first six months. As for overall growth, Oxford Economics keeps a diffusion index based on the number of Fed districts (weighted for their size) that record continuing growth. That number rose, but remains below the level sustained throughout the decade after the Global Financial Crisis.

The Beige Book doesn’t and shouldn’t play a major role in setting the direction of bond markets; but on this occasion, it suggested a clear direction and investors turned the other way.

They’d instead taken direction from the services ISM report for the US, which was significantly stronger than expected. However, again it’s not clear that that direction was warranted. The following chart shows the movement of the two components that matter most to the market at present — prices paid and employment — over the last 20 years. Both rose noticeably.

But the prices indicator remains far below the giddy peaks set last year, and perhaps more importantly, somewhat below its pre-pandemic norm. It doesn’t suggest an “overheating” or “no-landing” economy (pick your own metaphor) so much as a return to normal.

Also, the ISM Services survey isn’t necessarily the best economic indicator. Back in 2008, it remained obdurately in expansion mode at a time when the National Bureau of Economic Research would subsequently say that the US was already in recession.

It only collapsed decisively below 50 — the border between expansion and contraction — once Lehman Brothers went bankrupt. Joe LaVorgna, chief US economist at SMBC Nikko, offers a comparison that ISM Services’ performance is doing a little better now, but the pattern is similar enough to warn that the signal has proved nothing yet.

Shouldn’t the Tech Party Be Over Already?

There’s one odd corollary from the excitement in rates. Big Tech flourished when they were low on the theory that the sector had a long duration (its earnings were well into the future, so it benefited strongly from a lower discount rate). When rates surged in 2022, Big Tech tanked.

That turned around this year as the end of the tightening cycle came into sight and, crucially, artificial intelligence turbocharged new enthusiasm. But that rally surely can’t last forever. Google search data confirms that the initial surge of interest in AI following the launch of ChatGPT last November has now subsided.

And yet, the rally resumes. The graph below shows the ratio of the S&P 500 Information Technology Sector Index to the S&P 500 excluding tech as the white line (a gauge that excludes some of the mega-cap companies, such as Amazon.com Inc., which are not classified as tech stocks) and the NYSE Fang+ Index — an equal weight index tracking behemoths such as Meta Platforms Inc., Apple Inc., Amazon.com, Netflix Inc., and Alphabet Inc.’s Google — to the S&P 500 equal weight gauge as the blue line. Both tech-related indexes outperform their non-tech peers, and are close to their peak outperformance for the Covid era.

The bounce back for AI, concedes Lori Calvasina of RBC Capital Markets, provided “a somewhat confusing end to a summer in which a transition in leadership away from mega cap growth stocks that many investors had been hoping for seemed to be finally getting under way.”

She added that the tactical problems for the large-cap growth stocks hadn’t disappeared. The question remains. How can this make sense? Going by conventional thinking, FANGs should prefer low-rate environments. Are investors already discounting rate cuts (even though the bond market isn’t)? And could tech conceivably have further room to run? There are some good arguments that it doesn’t.

To Vincent Deluard of StoneX Financial, the big five platforms — Apple, Amazon, Meta, Alphabet and Microsoft Corp. — have fast evolved into “mature companies” whose massive revenues barely keep up with nominal gross domestic product growth. “Their collective net income fell to $263 billion in the past four quarters, down 9 per cent from $289 billion the year before,” he wrote in a recent note. “The fall in big tech platforms’ earnings is all the more striking as the Fed is effectively underwriting a portion of their profits.”

Deluard also highlights an unexpected development. Megacap growth stocks are outperforming value despite the increase in long-term yields. “If stock prices are the net present value of their future cash flows, higher rates should penalize growth stocks, which derive most of their profits from distant profits,” he said. Again going by conventional thinking, value, he posited, should outperform growth when yields rise.

The S&P 500 has gained 18 per cent year-to-date while the tech-heavy Nasdaq 100 has rallied more than double. The gains were driven in large part by the chipmaker Nvidia Corp., seen as a big beneficiary of AI, which has rocketed up some 230 per cent this year. But to Rob Arnott, founder of Research Affiliates LLC, the stock is “a textbook story of a Big Market Delusion.”

“Overconfident markets paradoxically transform brilliant future business prospects into even more brilliant current stock price levels,” Arnott wrote in a research note, citing shares trading at around 110 times earnings. “Nvidia is today’s exemplar of that genre: a great company priced beyond perfection.” And would Nvidia’s popping bring down the whole market? “It’s very possible,” he told colleague Vildana Hajric.

Another famous bubble-hunter, Jeremy Grantham, has warned in an interview with David Rubenstein that we’re descending from 2021’s great bubble and that this should normally be the deflationary period.

Personally, I think AI is very important. But I think it’s perhaps too little too late to save us from a recession. The deflationary forces from the tech stocks breaking in 2021, probably too big, the power of interest rates rising and depressing the real estate market, very negative, slow-moving influence, I suspect that they will once again dominate.

So why have tech stocks staged yet another comeback? An interesting analysis by DataTrek suggests that it’s about a desire for safety. Broadly, Apple is widely perceived as an impregnable source of cash flows, while Tesla is a play on the exciting but still unproven technology of autonomous cars.

When Tesla is in the ascendant, investors are confident and have plenty of risk appetite; when Apple takes the lead, they’re cautious and want safety. At the moment, Apple is ahead:

It’s of some comfort that tech’s latest resurgence seems more about the belief that there’s something secure and reassuring (think of Apple CEO Tim Cook) about tech stocks, and not about the excitement of disruption (think Elon Musk). But it’s only a limited comfort.

—Isabelle Lee

Survival Tips

Covid-19 is inching its way back into our lives. Listening to the White House press secretary give bulletins on the president’s Covid tests before he travels was a jarring step back three years. There was also something quaint about it. Covid restrictions were annoying, and latterly became increasingly inconsistent. But the pendulum has swung too far in the other direction.

Here’s my anecdote. In December 2021, during the omicron wave, I traveled from the US to the UK. It was necessary to take a test before leaving, another on arrival, and then isolate until a negative result came back. When one of my kids tested positive, the whole trip was delayed by 10 days.

Last month, I made the same trip. The week before we were due to leave, my daughter tested positive (on a home testing kit that we needed to report to nobody). After much agonizing, we waited until she tested negative, and then she crossed the Atlantic. Had we wanted to ignore the test and travel anyway, there was nothing to stop us.

There were about three mask-wearing passengers on the entire plane, apart from ourselves. Public statistics on Covid are no longer easily available and it’s hard to gauge just how serious the latest variants are.

Some of the hoops we had to jump through in the bad old days were absurd. On one occasion, I made a two-day trip for a family wedding, and had both my entry and exit tests at the same time, just after leaving the airport. That was legally correct, and ludicrous. The current rules are too permissive. Let’s be careful out there.