It is important to remember that currencies are always a relative price. Interest rates, growth, inflation, and external positions are all relative considerations in foreign exchange. However, it is also essential to consider the dollar’s reserve status and the Fed’s role in influencing Treasury yields across the curve. Of course, a key challenge in the current episode has been the implication of (potential) fiscal dominance now that government debt-to-GDP is above 100%. That might prove to be a constraint and set up what Dave Dredge has termed “the great stop loss risk.”
As we have noted for some time, macro resilience and another phase of inflation could prove challenging for bond markets and leveraged assets. For example, the re-acceleration in core inflation over the past few months in Australia to 4.4% suggests that the next move by the RBA is likely to be a hike of the policy rate. The context is extremely low implied volatility, equity, and credit risk premia.
As we have also discussed in the past, there is an intimate link between liquidity, volatility, and leverage. The paradox of the “Sharpe-ratio” (or value-at-risk) approach to managing exposure is that long periods of stability encourage market participants to take on more leverage when liquidity is plentiful. As a result, participants become short convexity and phases of stability lead to large episodes of instability. If you want to know where the future risk is, “follow the leverage.”
More debt is issued in US dollars than any other currency (40% of short-term debt and 50% of long-term debt). It is a key reason why the dollar remains pre-eminent as the global reserve currency and the Federal Reserve is central in setting the risk-free rate and liquidity. In turn, it is why we spend so much time assessing consensus beliefs on future US short term interest rates and the risk compensation of assets relative to those rates.
Tactically, the large re-pricing of the path of short-term interest rates in the United States has contributed to a self-reinforcing appreciation of the US dollar, especially relative to low yielding currencies. From our perch, you get paid a lot to hold the reserve currency, especially against the Japanese Yen and the Chinese Renminbi. Indeed, the relative interest rate differential suggests that the USDCNY ought to be trading well over 8.3 (chart 1).
Clearly the weakness in several key Asian currencies is correlated and reflects the relative weakness in growth momentum. Sustained macro resilience in the United States has been supported by irresponsibly loose fiscal policy. The consequence will likely be a higher path of interest rates and potential for a return of the bond term premium. With narrow risk compensation, stretched positioning and beliefs in equities, that’s probably not a bullish set up for the second half of 2024.
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