The trade-weighted dollar has jumped almost 15 per cent in six months and appears to have “broken out” into a long-term ascension. Will that suck cash back to the US as the Federal Reserve starts to boost its funds rate?
The last time the dollar rose and capital flew back to the US was in the late 1990s; it caused the Asian currency crisis and pushed Russia to default. It also caused the collapse of Long Term Capital Management, a highly leveraged and giant absolute return hedge fund.
Old Mutual Global Investors multi-asset head John Ventre says the flows from emerging markets and the stronger dollar are both “symptoms” of capital rolling back into the US, rather than one causing the other.
From September to November, flows into EM equity funds swung negative to the tune of €1.1bn or 0.5 per cent of total European managers’ EM assets under management, according to Morningstar data.
That is roughly one-fifth the size of the previous three months’ net inflows.
Ventre says those flows are unlikely to turn into a flood back to the US as happened in the 1990s.
“Even though I’m very reluctant to say ‘it’s different this time’ – I used to have a sticker on my computer monitor that said the opposite – it is different this time,” Ventre explains.
During the Asian crisis investors were being paid roughly the same for EM investments as they were for much less risky US positions. Predictably, they flowed out of risk into the more attractive US assets, Ventre says.
But that was because the Fed hiked rates to between 5 and 6 per cent, narrowing the gulf between US and EM yields to almost nothing, he says.
This time round the Fed is likely to stop at between 2.5 and 3 per cent, way below developing nations’ levels, he explains. US treasuries yield 2 per cent today, while Brazilian real sovereign debt yields 12 per cent, according to Bloomberg.
They were offered better returns and more safety in the US but this time around it is only safety that is on offer in America.
“So that should keep EM markets pretty stable, particularly oil importers,” Ventre argues.
Debt is also not an issue this time around, he adds.
“Reports of any kind of debt bubble in EM are exaggerated. There has been some issuance as there’s demand there, but all of these countries’ debt looks sustainable to us.”
Ventre argues as much of the new bonds are in local currency, the dollar’s strength is not inflating the cost of servicing them.
The dollar’s rise is accompanied by growing US treasury bond values, which Ventre says is “inconsistent” with the prevailing narrative.
“Bond markets are not pricing in significant interest rate rises in the US. If the dollar carries on then treasuries are a big sell, and if the treasury market is right, then the dollar is a big sell,” he adds.
Ventre believes the bond market is most vulnerable at the moment and the bond buying is predicated on exceptionally low inflation forecasts.
Newton Asia and emerging markets manager Jason Pidcock says equities around the globe will be pushed lower by the soaring dollar.
He expects the currency’s rise to continue until strangled by the Federal Reserve, as the dollar has “broken out” of a long-term down trend and has few impediments given the loose policy of other developed central banks.
From 80 six months ago, the dollar index has passed 92 and could easily reach for 100 or the 120 it hit in 2001, Pidcock says.
“It wouldn’t surprise me at all if we get to that level – it’s at a point where it’s feasting on itself,” he says.
“The stronger dollar is negative for equities as it is for commodities, but it’s not just emerging markets.”
Pidcock believes the Fed cannot allow the currency to appreciate so much, so it may be forced to start another round of QE, and will definitely not raise rates this year.
He expects a 10 per cent correction in equities this year, which could take anywhere between a month and six months.
Pidcock has opted for more cash and lower beta stocks in the meantime, while he awaits the chance to buy back in.
Last week, global stocks had fallen 3 per cent in just a few days’ trading in the new year, he points out.
Most emerging market funds will be meeting redemptions and that is likely to continue as the dollar rises, he says. But that will not impact the real economy of the nations with robust fiscal and balance of trade balances.
JP Morgan Asset Management currency chief investment officer Roger Hallam says many countries amassed large reserves during the trade surpluses of the 2000s, with much of it diversified across different currencies. That will reverse now as the nations – many of them oil exporters – slump into trade deficits and start balancing the books (in dollars) with the stored up cash.
“But these more elevated levels of the dollar are going to require higher interest rates to be maintained,” he adds.
Fittingly, in the world of the “new normal”, it seems the Federal Reserve will dictate the outcome.