Currency War Underway
The Fed says this is a Mid-Cycle Adjustment not the beginning of a series of rate cuts.
I strongly disagree. So does the bond market, and so does Alpine Macro.
In One Two Three Four, I Declare A Currency War Alpine Macro discusses the trade war, currencies, gold, and interest rate scenarios.
In global fixed income, the historical record shows that bond yields do not bottom with the first rate cut. The Fed is still behind the curve and needs to cut more aggressively to stabilize the economic outlook. Of course, if there is a major policy blunder and the economy heads into a recession, U.S. bond yields will collapse to zero.
Our bias is to short the U.S. dollar as the Fed will be the most aggressive of the major central banks to cut rates. However, given that the dollar is a perceived safe-haven currency, it could rally if risk aversion spikes. We have divided our short dollar exposure into three buckets:
1: Short USD/JPY. This is our hedge. USD/JPY should head lower in our baseline scenario where the dollar weakens as the Fed eases while the BoJ has virtually no room to do so. And if there is a meltdown in global risk assets, the Japanese yen will still outperform the dollar. The yen “trumps” the dollar when it comes to being a safe-haven currency.
2: Long a basket of the Canadian and Australian dollars. Chinese reflation, Fed easing and a weaker dollar will ultimately spell good news for the commodity complex. Admittedly, we could be early on this trade. It may take a deeper selloff in global risk assets, including commodities and related currencies, before policymakers reflate more aggressively.
3: Long EUR/USD. The euro could be the next target in President Trump’s currency war. Moreover, the ECB simply can’t match the Fed on easing policy. The Fed has more leeway to cut rates and resume asset purchases, if needed.
Finally, we recommend staying long gold. Bullion is a natural barbell asset. Gold will head higher as the Fed reflates and the dollar weakens.
The currency trades above are Alpine Macro calls. Without taking the other side of the bets, I can point out some reasons those calls may be wrong.
1: Japan can indeed cut more. The Swiss central bank rate of -0.75 is proof enough. For discussion, please see More Currency Wars: Swiss Central Bank Poised to Cut Interest Rate to -1.0%.
2: Business Insider reports the RBA is now considering the drastic measure of negative interest rates — meaning you could be paid to borrow money from the bank. And if the global economy is headed into recession, export-based economies like Canada and Australia may not do so well.
3: I agree with Alpine that the Euro is highly likely to be the next target in Trump's ever-changing trade war flip flops. But to what currency effect? And what about the pathetic nature of European banks? Brexit impacts will take a toll. And Italy, temporarily on the back burner will soon be on the front burner again with the Mini-Bot parallel currency idea and Italian budget deficits that break the rules.
On June 18, I wrote Meet the Mini-BOT: Italy Will Break Up the Eurozone. I stand by that assessment, but timing is unknown.
A showdown was temporarily averted, but the issue will arise soon enough as the Eurozone sinks in recession.
Monetary Madness Spotlight
Instead of focusing on the US dollar, consider the monetary madness everywhere.
- More Currency Wars: Swiss Central Bank Poised to Cut Interest Rate to -1.0%
- Inverted Negative Yields in Germany and Negative Rate Mortgages.
- Gold Blasts Through $1500: Message? Central Banks Out of Control, Not Inflation
- Yes, the Fed will cut rates.
Central banks will attempt to reflate which implies more monetary madness and escalating currency wars.
It's the monetary madness and currency wars that are good for gold, not the short-term fluctuations in the US dollar.
Mike "Mish" Shedlock