Money (cash and credit) is the foundation of the global financial system. It is the oil that flows through the economic machine, greasing the gears of commerce and allowing markets to turn.
Money serves three primary functions: a store of value, a medium of exchange and a unit of account.
All currencies are now fiat, meaning they have no intrinsic value. They are not backed by anything tangible.
Money is a system based on trust. This trust is complex and I am not sure many people consciously think about it. (Because this topic is complex and I do not want to get lost in the weeds, I will be making broad sweeping generalizations while focusing on the key points that matter.)
It is predicated not only on our opinions and expectations surrounding the currency issuers stewardship of its value, but the opinions and expectations of others as well.
A fiat currency is ultimately worthless if it is not fungible and others will not accept it as a unit of account, store of value or medium of exchange.
Since all currencies are fiat and not pegged to something fixed (there are pegged currencies but those are pegged to other floating currencies), their values, referred to as exchange rates, fluctuate relative to one another over time.
Like all market prices, exchange rates are driven by supply and demand. Currency supply and demand can be separated into two broad categories: fundamental and speculative.
Fundamentals are things like the trade and balance sheet of the currency issuer and its fiscal and monetary policies, such as its budget deficits and its control of the money supply.
Speculative demand is centered around expectations of the relative and future value of the currency. Think exchange rate trends, interest rate differentials and relative local market opportunities.
To simplify even further. Currency supply and demand is comprised of three things:
- Trade
- Non-speculative capital transactions
- Speculative capital flows
Trade affects exchange rates through the balance of trade. Countries sell goods in their home currency. For other countries to buy those goods, they have to exchange their currency for the seller’s (exporter’s) currency. And vice-versa for when the country wants to import goods. This differential is referred to as the balance of trade. A trade surplus is an appreciating force on a currency and a deficit is a depreciating one.
Speculative capital flows are the buying and selling of currencies with no attached underlying asset.
Speculative capital moves in search of the highest total return. Total return is made up of exchange rate differentials, interest rate differentials and the local currency capital appreciation.
Of the three, exchange rates are the most important because they tend to fluctuate more than interest rates or market returns. It does not take much of an exchange rate decline or increase to completely overshadow the return on interest rates or capital appreciation.
Non-speculative capital transactions refer to all other cross border capital transactions.
In the short term (months to a few years), exchange rates are driven by speculative flows. In the long term, economic fundamentals (trade and non-speculative capital transactions) dominate exchange rate movements. It is the dynamic tension between these two that comprise the trends and fluctuations of currency markets.
Here is one of the key points of the bigger picture I am getting at, via George Soros (Trades, Portfolio)’ "Alchemy of Finance:"
"Expectations about exchange rates play the same role in currency markets as expectations about stock prices do in the stock market: they constitute the paramount consideration for those who are motivated by the total rate of return."
And:
"To the extent that exchange rates are dominated by speculative capital transfers, they are purely reflexive: expectations relate to expectations and the prevailing bias can validate itself almost indefinitely… Reflexive processes tend to follow a certain pattern. In the early stages, the trend has to be self-reinforcing, otherwise the process aborts. As the trend extends, it becomes increasingly vulnerable because the fundamentals such as trade and interest payments move against the trend, in accordance with the precepts of classical analysis, and the trend becomes increasingly dependent on the prevailing bias. Eventually a turning point is reached and, in a full-fledged sequence, a self-reinforcing process starts operating in the opposite direction."
The point is that currencies are inherently reflexive.
Their tendency for large fluctuations make exchange rates the most important input in the total return equation. This means that as an exchange rate moves, it brings in speculators betting that it will continue to move. The longer the trend endures, the more reinforced this behavior becomes. This is until, of course, the exchange rate diverges too far from fundamentals and the trend following bias weakens. Then the process aborts and and works in reverse.
This is why some of the best trends (opportunities for profit) happen in the currency markets. It has a strong reflexive nature.
This brings us to my second point. The dollar.
The U.S. dollar is at 14-year highs after recently breaking out of its nearly 2-year consolidation.
For the last three months it has gone vertical without taking much of a breather.
This trend is the most important trend in global markets right now. Its effects will be wide-ranging. Those of you who have been with us for a while know we often refer to the U.S. dollar as the lynchpin of global markets. It is the main grease lubricating the global economic machine.
This is true when the dollar is in equilibrium. It is doubly true when it is trending.
This is because in macro there is something called the core-periphery paradigm, put forth by Javier Gonzalez in his book "How to Make Money with Global Macro."
In this paradigm, global currencies can be divided into three subsets:
- The reserve currency, which is currently the U.S. dollar.
- Hard currencies that come from countries that can lend to themselves at competitive rates. These tend to be net-importers of commodities. Hard currencies generally act as safe havens during periods of risk.
- Lastly, soft currencies. Soft currencies tend to be commodity producers. They are countries that have to borrow in other currencies at higher rates. These currencies depreciate during periods of risk aversion.
Since the dollar is the reserve currency, it is the preferred medium of exchange for global trade. It is also why commodities are priced in dollars.
Global capital sloshes around the world in search of the highest total return. So when the dollar appreciates due to the sum of exchange rate differentials, interest rate differentials and local currency capital appreciation, it attracts more capital (both speculative and, to a lesser extent, non-speculative). This creates the feedback loop.
But that money is coming from somewhere; and that somewhere is the periphery.
A higher trending dollar is a depreciating force on commodities and commodity producers (soft currency countries). A weaker dollar is an appreciating force on commodities and its producing countries.
According to Gonzalez, “Commodities rise for two reasons: investor flight to avoid a depreciating reserve currency and producers increasing their price to compensate for the depreciating unit of account.”
By that same logic, commodities fall due to capital flight back into the reserve currency (USD) and also from producers decreasing their prices to compensate for the appreciating unit of account. They then increase production as well to make up for the now lower income due to unfavorable exchange rate differentials.
There are other reasons — such as emerging market debt becoming more expensive when the dollar rises and the Federal Reserve’s interest rate policy affecting rates throughout the world. In addition, the amount of liquidity sloshing around is also a factor.
Simply put, much of the world lives at the mercy of the dollar and the Fed.
Due to this core-periphery dynamic, Gonzalez points out:
- On average, the cycles are longer at the core than at the periphery.
- Cycles are longer at the core when the reserve currency is appreciating than when it is depreciating.
This is perfectly logical. A depreciating dollar equates to higher commodity prices. Higher commodity prices feed into greater inflationary pressures.Higher inflation results in the Fed raising rates; increasing the total return profile of U.S. markets and holding U.S. dollars.
So a stronger dollar not only attracts speculative capital flows but also subdues inflation, which keeps real rates high and stays the Fed from tightening too much. Hence, this is why core cycles last longer when the dollar is going up.
Benign or vicious circle
For the last few weeks, I have been banging my head against the wall trying to understand the dollar dynamic at work. I think if I can understand this then I will be able to make a lot of money in the coming year.
Here is why it has been hard. The recent rally in the dollar is confounding a lot of currency models. These models say that at the current interest and exchange rate differentials, the dollar should not be moving higher against many of the major pairs (can be otherwise stated as the dollar is either fair or overvalued).
A number of currency analysts that I have a lot of respect for have been saying the recent move just “doesn’t make sense”.
When I first heard that my ears perked up. I have found in markets where you hear people saying a move does not make sense, it generally means the move is going to keep going.
Like Bruce Kovner would say, “I like to know that there are a lot of people who are going to be wrong.” The “doesn’t make sense” usually equates to “a lot of people who are going to be wrong”.
On a short-term technical basis, the dollar is overextended and I have been expecting a pullback. I think we will see one in the next few weeks. It could very well be a sizable one that lasts a couple of months. But my conviction on the longer-term dollar bullish thesis is growing. However, with the many unknowns surrounding the incoming administration, there are a number of things that could flip my viewpoint.
We are approaching a giant macro crossroads and the administration’s and Fed’s response over the next few months will determine where we head and whether the core (U.S.) benefits or the periphery (EM) prospers. Or as Soros would put it (and I paraphrase), “it will decide whether we have a vicious circle or a benign one.”
A benign circle for the United States is when the dollar appreciates and the bull market at the core (U.S.) is extended. A benign circle for the U.S. is a vicious one for emerging markets and vice versa.
Vicious or benign, if we are able to get our ducks in a row, we should be able to capitalize on a lot of opportunity.
Let’s run through each scenario so we will know what to look for as things unfold.
Benign circle: Stronger dollar/core benefits
Let’s go back to our total return equation of exchange rate differentials, interest rate differentials and local currency capital market appreciation to see how the dollar stacks up.
The chart below is of the real trade weighted U.S. dollar. The chart illustrates the tendency to move from long periods of equilibrium and stasis to long periods of aggressive trends. That is due to the reflexive process kicking in.
These trends drive exchange rate expectations that drive the trend. It is a safe bet to assume the exchange rate differential is a strong positive in the dollar total return equation. And it is becoming stronger.
Also notice that the symmetry in time between the last two dollar bull trends. The dollar bull market in the 80s started in 1978 and ended in 1985 (approximately 6.5 years). In the 90s it started in 1995 and ended in 2002 (approximately 6.5 years). The current dollar bull market started in mid-2011. If this bull market follows a similar temporal symmetry, the dollar should continue to rise until the end of this year.
The above chart (via Factset) shows the interest rate differentials. The spread between U.S. rates and its developed market peers is now at record-high levels. So we can say that interest rate differentials are a strong positive for the U.S. dollar.
Lastly, we have local currency capital appreciation, which means we need to check how the U.S. market is doing relative to the rest of the world (ROW).
This chart shows the performance of the S&P index over the EFA, an ETF that tracks over 900 developed market mid to large-cap companies excluding North America.
When the chart is trending down, it means the ROW is outperforming the U.S. and vice versa for when it is moving up. As the chart shows, the U.S. has been outperforming its developed market peers for over eight years.
Local currency capital appreciation is again a strong plus in the dollar total return equation.
For those of you who have read "Alchemy of Finance," Soros’ arrowed equation would look something like this:
↑(e+i+m) → s↑ → e↑
Where "e" is the exchange rate, "i" is the interest rate differential, "m" is the capital appreciation and "s" is the speculative capital flows. An upward arrow means increasing (for those of you with an eye for detail, I flipped the arrow on s. Soros used a down arrow to signify increasing speculative inflows which I think is confusing) and the side arrow is essentially an equal sign.
All the equation is saying — in an unnecessarily nerdy way — is that the dollar's current total return picture is conducive to increasing speculative inflows which will lead to further trend strengthening (i.e., reflexivity).
Here is my additional logic chain to add to this total return picture, which will drive expectations for all of the above barring no intervention by the incoming administration.
The prospect of a coming fiscal stimulus, the extended length of this bull market, the long period of time the Fed has stayed low on rates, historically high valuations and increasing speculation means greater propensity for the Fed to raise rates at a faster rate than the market is expecting. This means stronger total return for investors, more speculative inflows, higher U.S. dollar exchange rates and dollar asset/market prices and a greater chance the Fed becomes more concerned with asset bubbles than its inflation target, which will stay low from a stronger dollar, reflexive loop, a Goldilocks economy and market for the core over the short term and an unsustainable benign circle in the long term.
We can also apply this to the rest of the developed world.
A stronger dollar means low to lower commodity prices. Lower inflation, low valuation and sluggish economic growth means lower rates for longer in ROW, which will widen the U.S. interest rate differential. This means a stronger dollar and a benign circle.
Here is Soros on the power of benign circles (emphasis mine):
"The longer a benign circle lasts, the more attractive it is to hold financial assets in the appreciating currency and the more important the exchange rate becomes in calculating total return. Those who are inclined to fight the trend are progressively eliminated and in the end only trend followers survive as active participants. As speculation gains in importance, other factors lose their influence. There is nothing to guide speculators but the market itself, and the market is dominated by trend followers."
The logic chain as things stand now brings us to a stronger dollar, a core bull cycle and a benign circle. This is the 1998 to 1999 analog that we have talked about in past reports where the U.S. market runs higher. In combination with a stronger dollar and stagnating commodities and emerging markets, it would put us around the early 1999 time frame.
Soros said this about the benign circle that occurred in the early 1980s.
"Reagan’s benign circle was sustained by a differential in interest rates rather than inflation rates and there was an ever-growing trade deficit which was matched by an ever-growing inflow of capital. While in the first case it was possible to claim some kind of equilibrium, in the second case the disequilibrium was palpable.
The inflow of capital depended on a strong dollar and a strong dollar depended on an ever-rising inflow of capital which carried with it ever-rising interest and repayment obligations. It was obvious that the benign circle could not be sustained indefinitely."
Like Reagan’s benign circle and Clinton’s that followed, this market looks like it has tripped a strong reflexive function. A classic boom or bust sequence on multiple levels; one that could be extremely profitable in the short term but dangerous in the long term.
If this is the path we take then we want to remain concentrated in developed markets, particularly the U.S. We should look for stocks that will benefit from higher rates and not necessarily higher commodity prices. We want areas that fit around the Trump reflation and stimulus narrative and that are domestic focused; not vulnerable to higher exchange rates.
And, of course, we want to be long the dollar.
Vicious circle: Lower dollar/periphery benefits
The new administration rode a wave of populism into the Whitehouse. Trump’s platform is centered around American interests first and doing whatever it takes to bring back jobs, especially in the rust belt.
Many of those jobs are manufacturing jobs. U.S. manufacturers do not benefit from a rising dollar. Accusing China of artificially keeping the yuan weak in order to gain export share was a constant focus of the Trump campaign.
It is not difficult to imagine a scenario where the dollar rises enough to cause the Trump administration to intervene and reverse it, similar to what Reagan’s Secretary of Treasury Jim Baker did in 1985 with the Plaza Accord.
As President, Trump has the power to nominate members to the Fed’s board of governors; including the chair and vice-chair. We should see these nominees shortly after he takes office. These picks and the amount of influence he chooses to exert over the Fed could have wide-ranging impacts on the dollar and equity market outcomes.
If any significant interventionism does occur, it will start up a short and vicious circle. Money will flow from the core to the periphery. Inflation will rise and commodities will run. And there will be some great trades to be made.
The following chart (via Meb Faber) shows global value against the S&P 500 36-month trailing performance. Like what was shown in the earlier chart, the U.S. has been dominating the global investment landscape.
Here is the following from Meb Faber:
"But one regime sets the stage for the next, and now we find ourselves in an environment where US has outperformed everything since the 2009 bottom, but out performance alters values, and now the US is one of the most expensive stock markets in the world at a CAPE ratio around 27 (though nowhere near the peak valuation of 45 in 1999).
Foreign value has lagged badly, including three consecutive years of underperformance to the S&P in 2013-2015. This has pushed the CAPE ratio of the cheapest basket to a value of around 9 or 10, less than half the valuation of US stocks. (Actually it is almost a third the value of the US!) A global value approach is having a great year in 2016, and we look for that to continue for the foreseeable future.
So, maybe instead of chanting U-S-A, investors should be thinking C-A-P-E?"
U.S. valuations have only been higher two other times in history, 1929 and 2000. It is safe to say the rubber band is stretched and we will soon enough see things revert back the other way.
This also means that if the dollar were to reverse, there are some amazing value opportunities outside of the U.S. The chart below (via Greg Schnell) shows the CRB (Reuters/Jefferies Commodities Index) over the last 40 years.
The index is hanging around its 40-year low. Remember, commodities are a dollar story. This chart shows how much potential mean-reversion could occur in commodities if the dollar were to reverse. We are talking a significant multiyear trend and a huge profit opportunity.
If the dollar turns, we will buy up emerging markets and commodity linked assets hand over fist.
Conclusion
We are currently cruising along the benign circle road (stronger dollar) and our speed will only pick up barring any intervention. Since that is the road we are on, that is the road we need to game.
The way I see it right now (and this is liable to change) is that we will see the benign circle play out completely and the Trump administration will not do anything until the trend has already exerted itself. This is for a few reasons.
1) The stock market is going to be moving higher. Sentiment is going to be positive. Trump's administration has a big to-do list. There will be little incentive for him to rock the boat. He may even see the stronger dollar as a global vote of confidence in his leadership.
2) We are seeing improving economic numbers from around the world. The optics on this improvement are being multiplied by the base effects we talked about in last month’s report. The chart below shows manufacturing PMI numbers improving across the board.
3) If this dollar bull market follows a similar temporal symmetry to the last two, it should last roughly to the end of 2017. Trump and the Republicans will be working on tax reform, cutting regulation and planning infrastructure spending during that time. As long as the party keeps going, the dollar will be out of sight out of mind for the administration.
If I am right, the U.S. market will likely go on a tear higher from here (again, reflexivity). This will be accompanied by increased volatility in both directions. European and Japanese stocks should also perform well, especially exporters who benefit from a weaker euro. Many of these are trading at depressed levels and will likely do well over the coming months.
Commodities likely will not go down right away from a stronger dollar. This is because the deflationary pressures of a stronger dollar are being counteracted by a bump in improving global fundamentals (i.e., the above PMI chart). They may even trade slightly higher from here, but there is a ceiling on how much further they can recover as long as the dollar remains strong.
There will be a lot of opportunity in markets over the coming year regardless of which way things turn. And needless to say, we will be keeping a close eye on the dollar.
Above was an excerpt from our monthly Macro Intelligence Report (MIR). To learn more about the MIR, click here.
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