It’s up to U.S. stocks to carry out the coup d’etat on King Dollar.
Kit Juckes, a global strategist at Societe Generale SA, attributes the recent dollar rally to the same bond market trend that preceded the 2015 Chinese devaluation and subsequent selloff in risk assets. Traders are starting to get ahead of the Federal Reserve, he warns, with the five-year forward one-year U.S. rate — a proxy for what the market thinks the one-year rate will be five years down the road — “breaking free.”
“As rates rethink the Fed outlook, the dollar remains king of the foreign exchange market,” Juckes wrote in a note on Wednesday. “Last time this happened, it took a significant U.S. equity market correction to stop the move.”
This move in forward rates rejuvenated the world’s reserve currency. The U.S. dollar bested only three of the 17 major currencies tracked by Bloomberg in the first quarter. Now, halfway through the second, the Japanese yen and Norwegian krone are the only components of that basket doing better than the greenback this year.
For emerging market assets, the dollar’s ascent to fresh 2018 highs brings to mind what Richard Nixon’s Treasury Secretary John Connally once quipped: It’s “our currency but your problem.”
Emerging market bond funds have been dumped, damping the near-term prospects for issuance. UBS Wealth Management’s Geoffrey Yu has deemed the asset class a “falling knife” — and only a brave few are willing to try to catch it.
Srinivas Thiruvadanthai, research director at the Jerome Levy Forecasting Center, said he expects dollar strength to build, adding to pressure on developing markets. Fiscal stimulus — not only in the form of tax cuts, but also the removal of sequester caps — as well as easing access to credit will buoy activity and corporate profits, he reckons.
But the pain inflicted upon emerging market assets amid persistent dollar strength might limit the Fed’s ability to follow through with an abundance of rate hikes, he cautioned.
“Go back to 2013, initially it was the Fragile Five, it then blew up into an overall EM problem in 2014 to 2016,” he said. “It’s like ‘subprime is contained’ — the weakest link shows up.”
A basket of emerging market currencies compiled by JPMorgan is down nearly 6 percent in the second quarter.
However, there are few signs that dollar strength is meaningfully weighing on the S&P 500 Index at this juncture. Since the currency’s ascent kicked into high gear in mid-April, the U.S. equity benchmark has advanced 1.4 percent. Meanwhile, a Goldman Sachs basket of stocks with an elevated share of overseas sales is basically flat over this span.
U.S. stocks are just a “sideshow” to this major action in emerging markets, rates and currencies, Societe Generale’s Juckes said. But that might not last.
“Maybe a big move in emerging market foreign exchange won’t impact the outlook for U.S. rates, but a bigger move in U.S. equities would,” he concluded.