One week ago we showed just how severe the recent move in the USD, and alongside it 10Y Treasury yields – sparked by the April 17 PBOC RRR-cut – has been…
… and how sharply it affected not only Emerging Market currencies, but also EM bonds and stocks.
And, courtesy of Deutsche Bank’s Aleksandar Kocic, we also laid out the volatility-on/risk-off pathways that propagate as a result of the stronger dollar, resulting not only in a surge in risk asset vol and weakness across Emerging Markets…
… but threaten to undo the Fed’s carefully laid plans of the past decade to create unprecedented stability across the yield curve (for more details please see “Why The Soaring Dollar Will Lead To An “Explosive” Market Repricing: A Flow Chart“)
But what if the sharp dollar move higher is now over, and what if the market has already repriced the recent differentials in both capital flows and yields between the US and not just Europe but the rest of the world?
As BofA’s Athanasios Vamvakidis writes in a weekend note, a big driver behind the recent dollar move, a sharp short squeeze may now be behind us as USD market positioning has now adjusted to broadly neutral levels.
This is the case both with respect to G10 and with respect to EM FX. In fact, according to Bank of America, hedge funds are now long the USD, while real money remains short the USD, with the two roughly offsetting each other in aggregate positioning measures.
This, to Vamvakidis, means that the USD needs a new push. or trigger, to rally further, but according to BofA, there are a number of candidates.
Starting with the fundamentals, if US data continues outperforming Eurozone data, expect real money to cut their long EURUSD positions more, pushing the USD even higher. Indeed, last week’s Euro-missing and US-beating PMIs supported the USD; meanwhile the whisper number among most analysts is that after two consecutive months of sharp misses, this week’s NFP will surprise solidly to the upside.
This means that if the strong central bank USD selling which BofA has observed during the USD rally stops, the USD could appreciate to become more consistent with what data and rate differentials would already support.
But the biggest USD-wildcard is that we could start seeing large the US corporate profit repatriation flows that many have been expecting for this year and which have so far largely failed to materialize; in that case, the USD could rally even beyond the BofA baseline projection of 1.15 by the end of Q2.
Finally, among the more recent and unexpected developments, Italy has emerged as a major negative EURUSD risk, although it may become more relevant during the budget discussions this fall.
On the other hand, implications from trade policy uncertainty on the USD are less clear. This week, on June 1, the US exception from tariffs on EU steel and aluminum exports expires and the latest news out of Washington suggest it may not be extended, although the president is well-known to reverse policy positions on a dime as part of “negotiations.” Furthermore, trhe US is also looking into trade protection against car imports from the EU and other countries. Uncertainty about US trade protection against China remains, despite a preliminary deal early this week.
While it is true that trade war headlines have been generally negative for the USD this year, their market impact has been diminishing, and if anything could reverse, because according to Vamvakidis, should the US trade offensive turn against the EU in the weeks ahead, this will be more negative for EURUSD, given Europe’s high dependence on exports.
Finally there is the question of just how high the USD can rise without terminally impairing EMs. Here, the situation continues to be fluid as EM central banks continue to stem weakness in their respective currencies through aggressive policy moves and verbal intervention.
- Bank Indonesia continues with its aggressive verbal intervention though the actual intervention has been small and only to smooth out volatility than defend any level.
- Central Bank of Turkey hiked policy rates by 300bps in an emergency meeting this week, and on Monday the CBRT revised its rate corridor policy effectively tightening by 150bps, but despite that, BofA believes that any significant relief in TRY is unlikely.
Those two are relatively isolated instances of EM turmoil; the real question is what happens in Brazil and whether the recent selloff in the BRL and across Brazilian markets following last week’s trucker strike (which prompted the government to deploy the military to break it up), followed up the upcoming oil-workers strike, will be enough to push the BRL to the critical level of 4.00, which as a reminder, is according to Bank of America the best indicator and only relevant “trigger” for broader EM turmoil: “EM FX never lies and a plunge in Brazilian real toward 4 versus US dollar is likely to cause deleveraging and contagion across credit portfolios.”
Until then, however, it is smooth sailing for the USD, which today retraced all losses to close at a fresh 6 month high.