FM Wealth Management News Letter
When we look at the last six months, currency traders have had to
re-adjust to the dollar (UUP) diverging from rate differentials. In
simpler terms, the dollar and yields (TLT) are moving in different
directions.
Originally it was dismissed as temporary, but by looking at the EUR/USD chart since September (that is when the second leg of the yield rally was in full swing) tells us it isn’t going away any time soon.
If this isn’t enough to convince you, we are also including the USDJPY divergence.
It’s a Trilemma
A concept introduced by ING, the “Trump Trilemma” is in a note released the 15th February. They state,
“The conflicting market narratives of the Trump administration’s ‘America First’ economic policy agenda underscore the “Trump Trilemma” – which stipulates that out of three potential market dynamics, only two can co-exist at any one time. The three dynamics are as follows:
(1) rising bond yields (a function of greater government borrowing / rising supply of US Treasuries to fund fiscal spending)
(2) a weaker US dollar (to address US trade / external imbalances)
(3) confidence in the long-run US economy (at least relative to the rest of the world)”
Right now we can clearly see points 1 rising bond yields and 2 a weaker US dollar, which means there cannot also be point 3 a lack of long term confidence in the US economy. This may seem strange given the economy is apparently strengthening and US equities are at near all-time highs. ING explains this by:
“the heightened focus once again on the US economy’s ‘twin deficits’ – which has only been exacerbated by (1) the GOP’s debt-financed tax cuts and (2) the relative cyclical strength in other parts of the global economy.”
This was a point also made in a Unicredit note released in February. Where they describe how massive foreign inflows into the US since the financial crisis of 2008 are set to stop and potentially reverse. According to Unicredit:
“This is likely because US policy responses to the crisis were relatively timely, growth picked up considerably faster than in the rest of the world, while for most part of the last decade the euro area has been mired in disintegration risks and China has been in the process of rebalancing towards slower (albeit more-sustainable) growth. In effect, for many years US assets provided a very attractive risk-reward ratio and contributed to US investors’ increasing home bias.
But over the last couple of years, things have moved on, and on several dimensions: the eurozone has seen two consecutive years of growth higher than that in the US, EMU political risk premiums have dissipated, US assets have started looking very expensive and now the US administration is in the midst of pursuing unprecedentedly loose fiscal policy that will make the economy extremely vulnerable once the next cyclical downturn hits (and with the US business cycle being so mature, odds are that the next slowdown is approaching).”
Going back to the “trilemma”, yields and the dollar could therefore rise in tandem if the situation above changed. In other words if there was confidence in the long-run US economy (at least relative to the rest of the world) coupled with rising bond yields, then we would have to rule out point 2 a weaker US dollar.
So the next question becomes, “what has to change in order to boost confidence in the long term US economy?” Unfortunately this is where ING answers, ”we’re scratching our heads at finding any new positive US demand or supply shocks that could change the landscape for an economy in the 10th year of its expansion cycle.”
Both Unicredit and ING see the dollar continuing a downtrend for some time, could be even years.
On the other hand we could have a significant correction in US assets to make them attractive again. So if we look at the crash of 1987 which led to a positive correlation between the dollar, the S&P 500 (SPY) and yields after they moved in opposing directions for many years in a situation which is not unlike the one we find ourselves in.
We are not stating that this going to happen now, we just want to point out that it is a possibility.
Your Takeaway
The divergence in the dollar and rate differentials is continuing and many investors and analysts are wondering at when or what will make it end. We can tell you that the answer does not rest with the with the next inflation figures or the Federal Reserve, but squarely on the “Trump Trilemma” and long term confidence in the US economy compared to the rest of the world. Until this changes, we should be wary of any strength in the dollar as it is likely only temporary.
Originally it was dismissed as temporary, but by looking at the EUR/USD chart since September (that is when the second leg of the yield rally was in full swing) tells us it isn’t going away any time soon.
If this isn’t enough to convince you, we are also including the USDJPY divergence.
It’s a Trilemma
A concept introduced by ING, the “Trump Trilemma” is in a note released the 15th February. They state,
“The conflicting market narratives of the Trump administration’s ‘America First’ economic policy agenda underscore the “Trump Trilemma” – which stipulates that out of three potential market dynamics, only two can co-exist at any one time. The three dynamics are as follows:
(1) rising bond yields (a function of greater government borrowing / rising supply of US Treasuries to fund fiscal spending)
(2) a weaker US dollar (to address US trade / external imbalances)
(3) confidence in the long-run US economy (at least relative to the rest of the world)”
Right now we can clearly see points 1 rising bond yields and 2 a weaker US dollar, which means there cannot also be point 3 a lack of long term confidence in the US economy. This may seem strange given the economy is apparently strengthening and US equities are at near all-time highs. ING explains this by:
“the heightened focus once again on the US economy’s ‘twin deficits’ – which has only been exacerbated by (1) the GOP’s debt-financed tax cuts and (2) the relative cyclical strength in other parts of the global economy.”
This was a point also made in a Unicredit note released in February. Where they describe how massive foreign inflows into the US since the financial crisis of 2008 are set to stop and potentially reverse. According to Unicredit:
“This is likely because US policy responses to the crisis were relatively timely, growth picked up considerably faster than in the rest of the world, while for most part of the last decade the euro area has been mired in disintegration risks and China has been in the process of rebalancing towards slower (albeit more-sustainable) growth. In effect, for many years US assets provided a very attractive risk-reward ratio and contributed to US investors’ increasing home bias.
But over the last couple of years, things have moved on, and on several dimensions: the eurozone has seen two consecutive years of growth higher than that in the US, EMU political risk premiums have dissipated, US assets have started looking very expensive and now the US administration is in the midst of pursuing unprecedentedly loose fiscal policy that will make the economy extremely vulnerable once the next cyclical downturn hits (and with the US business cycle being so mature, odds are that the next slowdown is approaching).”
Going back to the “trilemma”, yields and the dollar could therefore rise in tandem if the situation above changed. In other words if there was confidence in the long-run US economy (at least relative to the rest of the world) coupled with rising bond yields, then we would have to rule out point 2 a weaker US dollar.
So the next question becomes, “what has to change in order to boost confidence in the long term US economy?” Unfortunately this is where ING answers, ”we’re scratching our heads at finding any new positive US demand or supply shocks that could change the landscape for an economy in the 10th year of its expansion cycle.”
Both Unicredit and ING see the dollar continuing a downtrend for some time, could be even years.
On the other hand we could have a significant correction in US assets to make them attractive again. So if we look at the crash of 1987 which led to a positive correlation between the dollar, the S&P 500 (SPY) and yields after they moved in opposing directions for many years in a situation which is not unlike the one we find ourselves in.
We are not stating that this going to happen now, we just want to point out that it is a possibility.
Your Takeaway
The divergence in the dollar and rate differentials is continuing and many investors and analysts are wondering at when or what will make it end. We can tell you that the answer does not rest with the with the next inflation figures or the Federal Reserve, but squarely on the “Trump Trilemma” and long term confidence in the US economy compared to the rest of the world. Until this changes, we should be wary of any strength in the dollar as it is likely only temporary.
TOTAL SCAMMERS: https://fma.govt.nz/news-and-resources/warnings-and-alerts/a-z-list-of-all-fma-warnings/#F
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