Weakening dollar spells the end of lucrative QE trades

Emerging market currencies, debt and stocks set to step out from greenback’s shadow

Jan Dehn




In 2016 and 2017, global financial markets slowly began the process of unwinding the big quantitative easing trades that had dominated both global capital flows and performance from 2010 to 2015.

QE itself only had a limited direct impact on markets, specifically by driving real yields to zero in developed bond markets. But it had a powerful second-order effect via global asset allocators, who responded by altering their allocation in favour of the QE-sponsored markets.

All of the major QE trades — namely being long US stocks, US dollar, core European government bonds and, most importantly, QE-sponsored markets (developed) versus non-QE sponsored (emerging) markets — made enormous capital gains. Since late-2010 the dollar has rallied 35 per cent in broad terms and 50 per cent against EM currencies, while the total return to US stocks is 430 per cent and German bonds have made more than 80 per cent. Against such enormous capital gains, the mere yield on offer in EMs was insufficient to prevent massive outflows.

Who, then, gets the biggest hangovers when the monetary punchbowl is removed? Those who imbibed the most. The slow process of monetary policy normalisation signalled by the Federal Reserve’s first rate rise in December 2015 started to unwind two of the big four QE trades. The dollar fell in both 2016 and 2017 and EMs rallied strongly as capital flowed back in.

Fast-forward to 2018, and the dollar has once again rallied while EMs have pulled back. But the dynamics at play here are temporary and the unwinding of QE distortions will continue to shape global market flows for years to come. This year has been a period of interruption, not of derailment.

One of the major harbingers of this interruption has been the US dollar rally, which has been driven by a large corporate tax cut, a hawkish Fed and the imposition of import tariffs.

These policy interventions were specifically designed to help Republicans in November’s midterm election, but they are unlikely to have a lasting positive effect. Election-motivated fiscal giveaways typically increase macroeconomic instability, while tariffs reduce rather than enhance productivity. Neither will sustain the 2018 dollar recovery.

At current valuations, the dollar looks to be about 20 per cent overvalued relative to EM currencies. This misalignment is evident in three independent economic relationships. First, a wedge of about 20 per cent to 25 per cent has emerged between real effective exchange rates in the US and EMs. Second, forward-looking growth differentials favour EMs over the US in the next five years to the tune of about 20 per cent. Third, the dollar is about 20 per cent overvalued relative to US productivity growth.

Having said that, the dollar is an extremely volatile currency, and investors should not expect to realise the 20 per cent upside in EM currencies in a straight line. Interruptions, such as the one seen in 2018, will happen again.

But over the medium term, the dollar will also suffer from America’s retreat from global leadership. America’s reward for sponsoring a rules-based system — comprising global conflict resolution, free trade, near-universal access to the US banking and legal systems, and the free movement of capital — was that the rest of the world willingly adopted the dollar as the medium of exchange for cross-country operations. In other words, the dollar became the pre-eminent global reserve currency.

As the US now increasingly replaces rules with discretion, greater riskiness will erode the willingness of other countries to continue to use the dollar. Diversification away from the dollar will initially favour the existing special drawing rights currencies (dollar, euro, renminbi, yen, sterling) but crumbs from the big table will also over time fall on to non-SDR currencies in EMs, especially the larger currencies.

With the midterm elections out of the way and dollar strength looking to subside, expect these reverse QE trades to re-manifest themselves strongly in 2019. In EM bonds, this should translate into strong performance for EM local currency markets due to the dollar’s weakness, and in EM high yield, due to spreads being well wide of historical averages. In EM equities, it should translate across the board as strong fundamentals shine through.

The unwinding of these consensus QE trades will not happen overnight. Central banks will take a long time to offload assets from their balance sheet, and institutional investors will take a long time to realise that this major shift is taking place. It took them five years to put on the QE trades, so it may take another five to unwind them. But it is important to remember that short-term volatility and headwinds can do little to upend this.


Jan Dehn is head of research at Ashmore Group

Behind the Market Swoon: The Herdlike Behavior of Computerized Trading

The majority of trades come from machines, models, or passive investing formulas that move in unison and blazingly fast

By Gregory Zuckerman, Rachael Levy, Nick Timiraos and Gunjan Banerji


Steven Mnuchin, U.S. Treasury secretary, right, speaks with Jerome Powell, chairman of the U.S. Federal Reserve, during a Financial Stability Oversight Council meeting at in Washington, D.C. Wednesday. Al Drago/Bloomberg News


Steven Mnuchin, U.S. Treasury secretary, right, speaks with Jerome Powell, chairman of the U.S. Federal Reserve, during a Financial Stability Oversight Council meeting in Washington, D.C. last week.

Behind the broad, swift market slide of 2018 is an underlying new reality: Roughly 85% of all trading is on autopilot—controlled by machines, models, or passive investing formulas, creating an unprecedented trading herd that moves in unison and is blazingly fast.

That market has grown up during the long bull run, and hasn’t until now been seriously tested by a prolonged downturn.

Since peaking in late September, the S&P 500 index of U.S. stocks has fallen 19.8%. The S&P is down 15% in December alone. It isn’t just stocks. Crude oil stood above $75 a barrel in October. By Christmas Eve it was below $43. Monday was the worst Christmas Eve for the Dow Jones Industrial Average in its history.

To many investors, the sharp declines are symptoms of the modern market’s sensitivities. Just as cheery sentiment about the future of big technology companies drove gains through the first three-quarters of the year, so too have shifting winds brought the market low in the fourth quarter.

 


—Erratic politics in large parts of the world. The U.S. and China are embroiled in a trade dispute. President Trump is openly denigrating the Federal Reserve on Twitter. Britain is fumbling through Brexit and Italy through an economic drought with consequences for its giant bond market.

The bouts of automated selling have landed in a market ill-prepared for it.

One measure of this is liquidity, the ease with which buyers can find assets to buy and sellers can find people to take assets off their hands. When liquidity declines, prospective buyers have to offer more or prospective sellers have to accept less. That makes swings in market prices bigger. It works both on the way up and on the way down.

Signs of diminishing liquidity can be found all across the markets.

The number of contracts available to buy or sell S&P 500 futures at the best available price has dwindled in recent years and dropped 70% over the past year alone, hitting a decade low, according to Goldman Sachs.

Boaz Weinstein, founder of credit hedge fund Saba Capital Management LP, said the market had been underpricing uncertainty. Now it’s taking into account political issues “at the same time as the Fed is hiking, the economy is slowing, and a lot of people are feeling like the best days for markets are over,” he said.

Mr. Weinstein says there are dangers building in the junk-bond market. One worry, he says, is that so many junk bonds—he estimated about 40%—are held by mutual funds or exchange-traded funds that allow their investors to sell any day they like, even though bonds inside the funds are hard to sell.

When enough investors want to cash out, such a fund has to start selling bonds. But without much liquidity, finding buyers could be hard.

A selloff could start simply, he said. “It has its own gravity.”

There are no apparent signs, analysts and portfolio managers say, of the economic imbalances that fueled the 2008 meltdown, which started with a housing bust that went on to infect the banking sector and eventually morphed into a full-fledged financial crisis.

The depth and speed of the market downturn are forcing a re-examination of conditions in the global economy and comparisons to previous market downturns that took place without economic recessions.

Some analysts see similarities to the late 1998 pullback in U.S. stocks that followed a year of turmoil in emerging markets, punctuated by the Asian financial crisis of 1997 and the Russian default of 1998 and culminating in the collapse of the highly leveraged Long Term Capital Management hedge fund.

Others point to the market shakeout in late 2015. Like the current episode, it lacked an obvious trigger and was accompanied by anxiety over the Federal Reserve’s plans to raise interest rates—in that case, the Fed’s first rate increase in nearly a decade. Like this year, the 2015 retreat featured a sharp decline in oil prices and a significant drop in the S&P 500.

In both those cases the market bounced back when investors regained confidence that the U.S. economic expansion was intact.

Most U.S. economic data and surveys of consumers and businesses are still optimistic. This month, the Federal Reserve moderately lowered its median projection of next year’s economic growth from 2.5% to a still-respectable 2.3%. Markets are telegraphing a darker message. Yields on 10-year Treasury bonds have fallen from 3.24% in early November to 2.74% just before Christmas, a sign investors think the economy won’t be solid enough to make steady interest-rate increases possible.

“There is a disconnect between what the financial markets are signaling about the economy and what the data are signaling,” said Catherine Mann, chief global economist at Citigroup.

Those sirens also include large drops in commodities like oil and copper, which hint at slowing global demand, and stress in the corporate-bond market. The spread between riskier high-yield debt and Treasury bonds widened to five percentage points from three percentage points in early October. Spreads moved at similar ranges between July and November 2007, one month before the most recent recession began.

Sentiment among chief financial officers, who help set budgets that will shape investment and hiring decisions, has also soured. Half of CFOs believe a recession will start within a year, and 80% think a recession will hit by the end of 2020, according to a Duke University survey.

“It’s not just about the equity market throwing a temper tantrum, it’s far deeper than that,” said David Rosenberg, chief economist at Gluskin Sheff & Associates in Toronto. “This is a much broader global liquidity story.”

Encouraged by signs of economic strengthening, the Fed has been gradually raising interest rates from rock-bottom levels and selling back the trillions of dollars in bonds it bought in the postcrisis years. The central bank says the roll-back of stimulus is smooth. Others aren’t so sure what comes next. There has never been such a huge stimulus, and one has never before been unraveled.

Some believe there's a hidden risk in debt that consumers and companies took on when borrowing was inexpensive. The Fed’s campaigns were “fundamentally designed to encourage corporate America to lever up, which makes them more vulnerable to rising borrowing costs,” said Scott Minerd, chief investment officer at Guggenheim Partners. “The reversing of the process is actually more powerful,” he said.

If The Fundamentals Are Still Bullish, Why Is The Market Crashing?

Macron, the Budget and the Yellow Vests

Placating the protesters could mean violating an EU budget rule – and compromising France’s leadership on the Continent.

By Ryan Bridges  

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