Saxo Q4 Outlook: Taking down the Killer Dollar

Saxo Bank, the online trading and investment specialist, has today published its Q4 2019 Quarterly Outlook for global markets, including trading ideas covering equities, FX, commodities, and bonds, as well as a range of central macro themes impacting client portfolios.

“2019 will most likely be remembered as the beginning of the end of the biggest monetary experiment ever — the year that kicked off a global recession despite the lowest ever nominal and real interest rates in history. Monetary policy has reached the end of a very long road and has proven a failure.” says Steen Jakobsen, Chief Economist and CIO, Saxo Bank. 

“In a global system of failed monetary policies and a long and difficult path to fiscal policy, there is only one other tool left in the box for the global economy and that is lower the price of global money itself: the US dollar.”

“There is an estimated USD 240 trillion of debt in the world, roughly 240% of global GDP. Far too much of this debt is denominated in US dollars due to the dollar’s role as reserve currency and the deep liquidity of the US capital markets.” 

“In this respect, the prospects for all asset classes become a function of US dollar liquidity and direction. If the dollar rises too much, the strain in the system increases: not only for US export, but also for the emerging market with its high dependence on USD funding and export machines.”

“Weakening the Killer Dollar will likely put the final nail in the coffin of the grand credit cycle that started in the early 1980s, when the US balance sheet was reset, and the USD was anchored by Volcker’s victory over inflation after Nixon abandoned the gold standard in 1971. The grand cycle since then has been turbocharged by globalisation and by lending money into existence via offshore USD creation.”  

“A weaker USD can only buy us some time; it won’t offer a structural solution. It’s the easiest quick fix to what ails global markets, and the one with the least political resistance. The mighty dollar is set to tumble. But be careful what you wish for, USA.”

Against this uncertain backdrop, Saxo’s main trading ideas and themes for Q4 include: 

The end of US equity outperformance

In August 2019, the USD reached a high enough level for the US Treasury Secretary Steve Mnuchin to declare that the US government does not intend to intervene in the USD for now — although he also said that the Trump administration had weighed up intervention. In other words, the US is planning to intervene if the Fed does not manage to weaken the USD through monetary policy. 

Peter Garnry, Head of Equity Strategy, said “Whenever the USD weakens equity markets should strengthen. As the world’s reserve currency, largest trading currency and the currency used in commodity markets, the USD is an important component in financial conditions. Since the 2008 crash, emerging market countries have seen a large increase in issuance of USD bonds which has added another growth constraint from the USD.

“If we break the period into regimes of stronger or weaker real USD, then a clear pattern appears. Whenever the USD strengthens, the US equity market outperforms the world ex-US and emerging markets and vice versa. Some form of USD intervention is the next logical policy step. Monetary policy has lost its effectiveness and fiscal stimulus is coming to slowly to offset the weakness in the global economy (the OECD’s leading indicators have been declining for 18 straight months). A great irony of any USD intervention is that it will partly help China, which is not exactly the strategy of the Trump administration but as with everything in life there are always trade-offs.

“In February 2019, equity markets celebrated the 10-year anniversary of the equity market bottom during the financial crisis. The celebration occurred with a historic equity outperformance over aggregate US government bonds of 339% or 16% annualised. This is one of the best 10-year periods for US equities relative to government bonds since 1973, only marginally topped by the dot-com peak. It is quite likely that the next 10 years will not offer attractive equity returns in terms of outperformance and especially not when factoring in the downside risk relative to upside risk.

“Investors attempting to escape low yields with pure equity exposure are running portfolios that are at risk to policy mistakes and a potential global recession — which has a probability of around 25-40% within the next 6-12 months.”

If the Fed won’t kill the dollar, Trump will be happy to lend a hand

We have been trying to call the US dollar weaker this year, with the caveat that the path might prove difficult as the Fed would have to get ahead of the curve — which it has thus far not been able to do. Market expectations are that the Fed’s policy path will remain largely unchanged from where they were a quarter ago, and there is increasing evidence that the Fed may not have the tools – or more importantly the will – to get ahead of the curve. Enter the Trump administration, which is likely set to pull out all of the stops

John Hardy, Head of FX Strategy, said: “As foreign central banks have lost their ability to, and interest in, accumulating USD reserves, the funding for these deficits has largely shifted to domestic sources. US savers’ and US banks’ balance sheets simply can’t absorb the torrent of issuance. Something has to give, and that something will be the Fed: whether it wants to or not.

“So far, the Fed has proven too cautious to get ahead of the issue. But in Q4, it is likely that they will be forced to respond in ever larger amounts to further liquidity provision. More importantly, the Trump administration may wrest control of policy.

“A heel-dragging Fed and dark clouds gathering over the economic outlook almost ensures that the Trump administration will be scrambling for the funding it needs to ensure Trump’s re-election in 2020. Ironically, after a quarter in which the entire world fretted the risk of perma-deflation, this policy mix almost guarantees that we are set firmly on the path to the return of inflation, and likely stagflation.”

For the Asia Pacific region the US Dollar is top of mind

The US trade-weighted USD basket is trading at all-time highs and USD, like an unchecked fire, has continued to draw oxygen out of the room with its steady grind higher this year. This, despite overall lower hedge fund positioning on dollar longs as well as jawboning from Team Trump. Why has the dollar been so strong and market participants so wrong on the USD call this year?

Kay Van-Petersen, Global Macro Strategist, “It’s a relative world, and the US has continued to outperform the rest of the world economically. Despite starting to cut rates, the Fed still has by far the highest yielding central bank rate in the developed world, at a time when a host of other countries have been relentless with cuts. Trump’s tariffs and international posturing is causing more pain for the rest of the world than it is for the US, thereby reinforcing the US outperformance of the RoW. His actions are strengthening USD, not weakening it.”

“Running on tariffs may make Trump come across as stronger to his voting base — as well as allowing him greater control of the news flow in 2020. Not to mention that he may be able to justify a bigger fiscal spend down the line if the economic headwinds from the tariffs continue. For now, there is no bear-term ceiling on the Dollar/Yuan as long as Trump is on the attack.”

Commodities: Weaker dollar propels gold to the next level

The global fiscal panic which we gave special attention in our last quarterly outlook could, over the coming months, be joined by a weaker dollar. The combination of these two developments will, despite recessionary risks, provide underlying support for metals (industrial and especially precious) as well as key US agricultural commodities depending on a weaker dollar to compete with producers from other regions.

Ole Hansen, Head of Commodity Strategy, “Gold, which finally left five years of range-bound trading behind to reach our $1485/oz target, looks set to continue to benefit from numerous tailwinds over the coming months. The Q3 rally was driven by the collapse in global bond yields — without any support from the dollar which strengthened by almost 2% against a basket of major currencies. We maintain a bullish outlook for gold, based on the assumption that the dollar will weaken and global bond yields stay low.

“The biggest risk to our scenario of rising commodity prices is the potential for a major trade deal between the US and China reducing the markets’ expectations for how much US rates will have to fall.

"Crude oil remains stuck in a wide range, with the pendulum continuing to swing between the risk of lower demand as global economic activity slows and the risk to supplies from sanctions and conflicts. The IEA sees the risk of a supply glut emerging into 2020 with OPEC and other producers potentially being forced to cut production in order to avoid an even lower price.

“The mid-September drone attack on the world’s biggest processing plant in Saudi Arabia showed just how vulnerable the global supply chain can be.  A supply-driven price surge at a time of slowing demand rarely ends well. While we see Brent crude at $60/b by year-end a geo-political risk premium is likely to keep the market higher during the coming weeks until Saudi production normalises, and the threat of a conflict hopefully begins to fade.”

USD liquidity: It’s going to get worse before it gets better

There is only one thing that really matters these days, and it is global USD liquidity. We operate in a dollar-based world, so USD liquidity serves as a key driver of the global economy and financial markets. Since 2014, the world has faced a structural problem of dollar shortage on the back of the Fed’s quantitative tightening (QT) and lower oil prices leading to less petrodollars in circulation.

Christopher Dembik, Head of Macroeconomic Analysis, said: “The massive US Treasury issuance taking place in a period of pre-existing high USD demand will drain liquidity out of the market and further tighten financial conditions in the fall (October/November), ultimately increasing risks to market segments that are already in a fragile position. Going into 2020, the view is more positive, as financial conditions and USD liquidity will improve. Central banks should go big in the coming months to cope with global trade recession, trade war friction and global slowdown.

“After years of massive central bank asset purchases, central bank liquidity has started to contract since early 2018. There is an emerging trend: central bank liquidity is slowly turning. It is still deeply in contraction territory, but it is moving upwards, currently at minus 2.5% of global GDP. For now, the bulk of the improvement is related to positive liquidity injection from the BoJ. Other global central banks will follow as tightened financial conditions push the Fed into a dovish corner and as the ECB will need to support the euro area economy for a prolonged period.

“We may also start to see an improvement of our favorite macro gauge, the global credit impulse, that points out to a potential global growth rebound in H1 2020, mostly driven by the US. Based on our latest update, US credit impulse stands at its highest level since early 2018, at 1.2% of GDP. The effect of the credit impulse will be amplified by fiscal push in many countries. If it is confirmed — and this is still an early call — it could open more positive macroeconomic and market perspectives for 2020.”

Monetary madness in the ‘miracle’ economy

The drumbeat of negativity and ubiquitous uncertainty resounded through markets over the summer as the trade war escalated, PMIs collapsed, and multiple geopolitical flashpoints came to a head. The USD, meanwhile, remained strong — breaking out to its highest level in over 20 years —tightening financial conditions globally, killing any green shoots and cementing the path for weaker economic growth. This culminated in the global “race to the bottom” dominating the narrative over summer and resultant highly correlated price moves across a whole host of assets.

Eleanor Creagh, Market Strategist, commented: “Political discontent remains unresolved, and slower growth and lower interest rates will persist throughout an extended period of economic underperformance. In Australia the RBA will be cutting the cash rate again in October, and in the US the FOMC will deliver another 25 base point rate cut by year end as US growth catches down to the rest of the world.

“With respect to trade, the real problems are still unresolved, and President Trump still has a Twitter account ready to unleash of volatility. Despite the temporary ceasefire, tariffs have been hiked in May and September and uncertainty is rife. This weighs on confidence and capital spending decisions and accelerates the bifurcation of global trade and technology.

“An interim deal addressing the trade deficit could be reached but there appears to have been no progress made on key issues such as IP reforms, technology transfer practices or enforcement of any deal. The underlying dynamics which reach far beyond trade call for continued escalation in tensions, despite any intermittent off ramps, which means that over the medium-term pressure on risk assets lingers.

“The relationship between the US and China has fundamentally changed. We have crossed the Rubicon in terms of the potential for these ructions to trigger a broad economic dislocation. Equities remain in a precarious position, near all-time highs as the business cycle continues to slow, earnings growth fades against consensus estimates remain too optimistic. Dollar liquidity is tight, and the risks of a bleed of recessionary dynamics in the manufacturing and industrial sector into services, jobs and the consumer are building. Monetary stimulus, meanwhile, provides less of a cushion than in previous cycles.”

To access Saxo Bank’s full Q4 2019 outlook, with more in-depth pieces from our analysts and strategists, please go to: www.home.saxo/insights/news-and-research/thought-leadership/quarterly-outlook