Strategists and speculators at odds over dollar outlook

Consensus among banks is for declines but market positioning tells a different story

Eva Szalay

Wall Street’s foreign-exchange strategists are at odds with speculators over the outlook for the dollar, underlining the uncertainty over the direction the world’s reserve currency will take next year.

The consensus among banks is that the dollar will decline in 2019, with much of the weakness expected in the second half of the year as shifts in monetary policy begin to favour other currencies, including the euro. However, that prediction comes as speculative bets on an appreciation in the dollar stand near the highest levels of the year, according to data from the Commodity Futures Trading Commission.

“Most banks and FX strategists think that the dollar is going to go weaker next year, but — interestingly — positioning tells a very different story,” said Andreas Koenig, head of global forex at Amundi Asset Management. “At the moment the market is very long dollar so it’s either the prediction for a weaker greenback that’s wrong or the markets’ positioning. It doesn’t add up.”

The past 12 months have offered a reminder of the dangers in being too confident in forecasting currencies. At the start of this year, the consensus among most investors was that the dollar would continue to weaken — a prediction that came unstuck in April as the clear outperformance of the US economy saw the dollar index, a broad measure of the currency, jump 8 per cent in a matter of months. Its strength hit emerging market economies with current account deficits and lots of dollar-denominated debt, but also offered the European economy some relief via a weaker euro.

As the Federal Reserve persisted in tightening monetary policy, investors rediscovered the appeal of dollar-denominated assets as the attraction of riskier bets, such as in emerging markets, eroded.

Mr Koenig said that being long the dollar and US assets had been “a very popular trade this year” because it was a low-risk asset that also had an attractive yield.

The consensus view for a weaker dollar in 2019 is built on the assumption that weaker growth in the US prompts the Fed to stop raising interest rates, while the European Central Bank continues to withdraw stimulus. Analysts at UBS argue that “we think the dollar is likely to depreciate over time as policy normalisation gets under way in Europe and Japan”.

What Has Happened to Us

The global system that many fear is dying is already dead. The new one has yet to emerge.

By George Friedman  

Last week, we published our annual forecast, which goes on for 40 pages. The length is necessary, but it risks obscuring the fundamental question: What has happened to us? From Shanghai to Moscow to Brussels to Washington, there is a sense that something has gone wrong with the world, with our nations, with our friends and even with ourselves.
The feeling has permeated our societies. We have gone from a belief in the end of history, in a final reconciliation of all our major contradictions, to a sense of failure, foreboding and betrayal. The sense is everywhere, and it came upon us with startling speed. A decade is a second in the history of humanity. The new year is the future, and the global sense of increasing failure will grow. But our future is embedded in the past, and the past must be grasped.
A Decade of Fear
Humans cycle between complacency and fear. When the time for fear comes, we magnify the threat. It’s a natural response; after all, when things go wrong, we humans need all the energy we can muster to face it, and terror is the most powerful of feelings. In the late summer and early fall of 2008, we faced the sum of our fears. On Sept. 15, 2008, Lehman Brothers collapsed. All its debts went unpaid. Those who were unpaid could not pay others, and that failure forced the economic system to face the abyss. It’s a familiar story by now, but its telling always omits something that happened just a month before, on Aug. 8. That day, war broke out between Russia and Georgia, and Russian tanks – a nightmare to the West a scant generation earlier – were on the move once more.
At the end of a war, the winning coalition dreams of a world in which its will continues to govern, where the differences among its members are settled with quiet goodwill, and where only good things will happen. Yet the end of the Cold War had not created a stable platform for eternal prosperity, nor had it made war obsolete. It hadn’t even settled the Russian question. The idea that any conflict could be the war to end all wars is the first product of victory and the most heartbreaking illusion. We made the same realization in 2008 in the space of seven weeks. The interests of the world were the same as ever, and the heartbreaking illusion returned. And since we are human, we knew that someone betrayed us. The idea that this is the human condition and that hostility and disorder are our natural state is too painful to contemplate. If the eternal peace that Immanuel Kant promised and that the fall of the Berlin Wall delivered dissolved, then it must have been the work of dark and vile forces.
In the wake of World War II came Maoist mass murder, the imprisonment of Soviet war heroes in the Gulag, Joseph McCarthy’s crusade against latent communism in the U.S., and all that these phenomena spawned. War is fought out of fear. The hubris of victory hides but does not abolish that fear. We should not be surprised at where we are now. The greater the victory, the greater the disappointment. Much went well after World War II, but the expectations exceeded the possibility.
The Revolution of Rising Expectation
During decolonialization in the 1950s and 1960s, a phrase became commonplace: the revolution of rising expectation. It meant that with the end of colonialism, the expectations of the developing world grew beyond what was reasonable. The disparity between expectation and reality then engendered disappointment and anger, which gave rise to instability. The same concept applies to the world after 1992: We expected a world without conflict, of common interests and values, and of increasing prosperity. It was a hope as inevitable as it was far-fetched. What came out of 2008 was a world plunged into fear and a rising sense of betrayal. That has matured now into a world in which fear, distrust and mutual contempt define political life in all spheres.
The events of 2008 brought to maturity the processes that had been underway in the past. Today the household income of someone in the fourth quintile – where the lower middle class is located – is about $35,000 a year. Accounting for taxes, and ignoring the cost of health insurance, we can generously estimate that lower middle-class families bring home $2,500 a month. When I was a child, my family was firmly in the lower middle class. We had a small house, a car and enough money to take modest vacations. These are luxuries the lower middle class cannot afford today on $2,500 a month.
Inequality was never the issue in the United States. The issue was attaining the American dream: homeownership and the promise of upward mobility for the next generation. That’s gone now. Though it had been dying for decades at the hands of a variety of forces, 2008 convinced the lower middle class that it wasn’t coming back. Even at the median income level of above $50,000 a year, the pain has subsided but not evaporated.
The current anger and drug addiction in the United States is a uniquely American problem. But the same sense that the world has turned against its poorer citizens and that the elites couldn’t care less has also spread to Europe and could be found in China and Russia as well. It became a global reality, and the immigration issue jelled it. Unable to understand the bitterness their countrymen felt at suffering national indifference while foreigners received care and attention, the elite sought to paint the lower middle class as xenophobic.
Leaders around the world have seized on this feeling. Xi Jinping became dictator of Chinabecause he arrested members of the elite. Vladimir Putin has stayed in power for nearly 20 years with promises to make Russia great again. The European right grasped the degree to which the Continent’s elite had once again become indifferent to the plight of their compatriots. And in the United States, the Democratic Party framed itself as the party of the working poor but focused on everything else, while an outsider took control of the Republican Party – historically the party of corporations – by mobilizing the underclasses. In each of these countries – including Russia, now that oil prices are in the $40 range – the disappointment of what used to be the working classes is in full bloom, confronting an elite that is relieved just to have a functioning banking system and believes, by extension, that all is well.
The distrust is not new. But the inevitable failure of the fantasies of the post-Cold War world has given it tremendous power.

Tensions Beget Tensions
Along with the tensions within nations are the tensions between them. In 2008, Russia announced it would not go gentle into that good night. Its brief war with Georgia was a subdued overture to what has since arisen. The tensions between countries have mounted, in part because nations are afraid of other nations and seek to protect themselves by being more fearsome. In our time, however, the problem is more complex. Between 1992 and 2008 the global economy surged as emerging countries built their economies on exports. The recession after 2008 hurt these countries badly, whether they exported manufactured goods or energy. Perhaps more important, what importers had tolerated and even benefited from they could no longer abide.
Cheaper exports were not a universal boon. On the whole, they benefited important countries, but people do not live “on the whole.” When vast segments of the population are victims of imports, or see themselves as such, the political system will destabilize regardless of whether the state is benefiting in a general sense. Indeed, the fact that the benefits accrue to certain classes while others lose their jobs increases the anger. Those who gain from the arrangement don’t understand what the fuss is about, and their incomprehension inevitably inhibits their response. The debate turns to the question of who is responsible. Whatever the reality, those who benefit will wind up with the blame, and the task of stabilizing the system falls to politicians.
The growing distrust within nations drives the growing distrust among nations. In many countries, the political order is in the midst of a transformation. Individuals and parties that one could not have imagined holding office a decade ago are now in power or close to it. International conflicts that appeared well-contained within the framework of the Cold War coalition are bursting at the seams. The Cold War coalition is increasingly at odds with itself, as new and unfathomable coalitions emerge, and dangers we thought we had buried in 1992 are coming back to life. Among those who saw themselves as managing the coalition, a sense of horror is inevitable. But that coalition, like the Congress of Vienna, the League of Nations or the United Nations, could survive for perhaps a generation at most. What had bound these groups’ members together was the enemy. A defeated enemy is simply not a strong enough glue to do the job.
New World, New Rules
The world has abandoned the rules of the Cold War coalition. This was inevitable. The 2008 crisis was going to happen in one form or another, and it would speak with authority. A new world would grow out of it. You can see our vision of how this plays out in our 40-year forecast or from my books, but that is unimportant right now. What matters is understanding that the world forged in 1945, the world that defeated the Soviet Union, is gone now. It left behind profound social tensions that the elite will ignore, until they no longer can, and a new international system. The new system, though born of the old one, is very different.
We are not going back. The vast social and political animosity tearing at the fabric of the world will resolve itself, perhaps with blood but likely without it. It will leave behind a changed world. That’s our point about 2019. It is a year in which an old world has already died, but many still think it can be resurrected. It is a year where the new world has not yet emerged. There are those who will welcome it. There are those who will loathe it. It will be what it must be – a new world with new rules. History is profoundly indifferent to our preferences. We live. We die. We love. We hate. We do so all under the pressure of reality. And the world is on the Edge.

Think Local When It Comes to China’s Debt

One of the biggest areas of vulnerability in China’s huge debt pile is bonds issued by investment vehicles linked to local governments.

By Andrew Peaple

A woman walks at the construction site of a 'red tourism' attraction featuring Chinese Communism, in Shazhou village located in Hunan province, China on Dec. 3.
A woman walks at the construction site of a 'red tourism' attraction featuring Chinese Communism, in Shazhou village located in Hunan province, China on Dec. 3. Photo: shu zhang/Reuters 

All politics is local, runs the old saw. In China, local governments lie at the root of the country’s debt problem—a problem likely only to grow in 2019.
Most analysts see the Chinese government’s relatively low debt—equivalent to around 16% of GDP at the end of 2017, according to Moody’s—as a strength. But add in both official local government debt, and debt issued by off-balance sheet financing vehicles backed by local governments—known as LGFVs—and that ratio climbs to 60% of GDP.

These LGFVs, which started sprouting up after the global financial crisis, have become an area of huge vulnerability. Back then, Chinese local governments were restricted from issuing their own debt, but still needed to stoke the economy. The solution: set up off-balance sheet vehicles which could issue debt, often collateralized with local government-owned land, and spend the money raised on big investment projects.
In recent years, local governments have become freer to sell their own official debt, but they still face centrally-imposed limits on how much they can issue. With tax revenues declining as Chinese growth slows, and another of local governments’ big income sources—land sales—highly volatile, they face an annual funding gap equivalent to around 10% of China’s GDP, Moody’s reckons.

This persistent revenue shortage has left local governments still reliant on LGFVs to keep issuing debt to fund investment. LGFV bond issuance has grown rapidly this decade; and despite a dip last year, it reaccelerated in the first half of 2018.

Cracks in this system are starting to show. A big concern is that many of the investments LGFVs have made over the years can’t and won’t generate adequate returns. Beijing’s crackdown on shadow banking has put the squeeze on investing entities that have been big buyers of LGFV debt. In turn, funding costs have been rising, particularly for lower-rated LGFVs, meaning interest payments are becoming an ever greater proportion of local government spending, particularly in poorer areas of China.

A big question now is who will bear the fallout if—as many analysts expect—LGFVs start defaulting on bond payments in big numbers. Investors have long assumed these financing vehicles have implicit backing from local governments and, ultimately the central government. Beijing, though, has been trying to dispel that impression, with a series of measures imposed to cut the potential support from local governments to the LGFVs.

If Chinese regulators allow a spate of defaults on debt long believed to be quasi-government, confidence in China’s bond market—vast swaths of which are priced as if they have Beijing’s ultimate backing—could plummet. Conversely, heavy government bailouts would lead to a reassessment of Chinese central government debt levels, and hence a potential repricing of government bonds.

Either way, the hangover from China’s local government debt binge is about to get very interesting.

China Quietly Dumps Bonds

by: SL Advisors
- China and Japan have historically been the biggest foreign investors in U.S. debt.

- Over the past year, both countries have reduced their U.S. bond holdings with no discernible impact on yields.

- Despite the expected rate hikes by the Fed in 2019, it will continue to be hard for fixed income investors to beat inflation after taxes.

Fear of foreigners dumping U.S. bonds has periodically resurfaced for as long as most market participants care to remember. One country's trade deficit is another one's surplus (although they puzzlingly never net out globally). In the U.S., we import more than we export, and conveniently, the surplus dollars our foreign trade partners accumulate are partially reinvested back into U.S. government bonds, which helps finance our Federal budget deficit.
China and Japan have historically been the biggest foreign investors in U.S. debt, each holding over $1 trillion for the past several years. Last year, China replaced Japan as our biggest foreign creditor.
From time to time, some commentators have warned that China retained the ability to inflict havoc on America's bond market if they decided to sell a chunk of their holdings. Their willingness to maintain such substantial holdings of government bonds presumably contributes to today's historically low long-term rates.
Trump has imposed tariffs on Chinese imports with little regard for such concerns. Following the 2016 election, China increased its U.S. bond holdings substantially. Japan was more cautious. But both have been reducing them over the past year. China's moves have been more recent and coincide with the growing trade spat. Interestingly, there's been no discernible impact on bond yields.
China owned as much as 22% of all our foreign-owned debt five years ago and is now down to 18%. Since May, they've shed almost $60 billion, with no visible market impact.
The idea of the U.S. as a supplicant to foreign creditors never made much sense to me. China owns what they own because it suits their purpose. They clearly perceive enormous value in U.S. sovereign debt because they're not earning much interest. So, the idea that they'd sell a large chunk because of a dispute has never seemed logical, as I wrote in Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. If you owe a trillion dollars, your creditor has much to worry about.
Sure enough, there's been no mention of foreign bond sales during the recent bout of trade friction. China has quietly reduced its holdings with little fanfare. Interest rates have remained low, even with the Federal Reserve raising short-term rates and unwinding quantitative easing.
The fear of foreign sellers driving up U.S. mortgage rates has even less basis than in the past.
Although the Fed is expecting to raise rates twice next year, bond yields continue to forecast less than that. For fixed income investors, it continues to be hard to beat inflation after taxes.
Equities are cheap, as shown recently by the Equity Risk Premium (see Stocks Are the Cheapest Since 2012). The American Energy Independence Index yields 6.9%. Bonds are unlikely to provide much value.