The US Dollar bull market is reasserting itself

The next chart tracks the performance of the Euro versus the US Dollar. As can be seen, the Euro, having fallen by 25% into March this year, has been tracking sideways to slightly higher for a number of months. It would appear that the bigger US Dollar bull market is reasserting itself, and with Draghi sponsoring this move, we expect a test of the 1.05 lows quite quickly, and ultimately a move to parity.

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But what of the larger picture here? Despite an improving growth picture in recent quarters, and the likelihood that both growth and inflation will tick higher in the next couple of quarters, Draghi chose to pre-announce substantial action. Is he truly worried that the risks emanating from China are large enough to warrant such action? Or, is he trying a bit of shock and awe; perhaps trying to weaken the currency which he stated is important to growth and inflation?

Another wave of currency wars

If Draghi’s main aim is to weaken the Euro (and that is certainly the view in the FX market), then he risks igniting another wave of competitive devaluations (a.k.a. currency wars). This would be bad news for global growth and ultimately could be bad news for equities despite what appears to be a very bullish market buoyed on by the ECB. Of course, this path is not set in stone, but it is easy to imagine other countries wanting to keep their currencies weak if the Euro falls substantially on the back of ECB largesse.  

What was interesting on Friday was that when China cut interest rates and reserve requirements, not only did equities add to the ECB inspired gains, but commodities and Emerging Market currencies EMFX) rallied too. However, commodities and EMFX soon turned tail and closed lower for the day which was bearish price action in our opinion. Fears that commodity demand will remain weak if the Chinese economy is still struggling is part of the explanation. However, a strong Dollar can also be blamed as we all remember how the strong Dollar was a significant driver of weakness in these areas over the summer.

A major risk in the weeks/months ahead is that Japan and China capitulate and move to weaken their currencies along with the Euro. This would encourage similar action by other central banks and unleash a wave of deflation that will likely be coincident with poor returns from commodities and EMFX, perhaps followed by US credit and equities and ultimately all risk assets.

 We doubt that this is what Draghi really wants, but his words and now potential actions appear to be designed to weaken the Euro. Historically, currency wars and other beggar-thy-neighbour policies are a disaster for the global economy and also financial markets. If other central banks refrain from following Draghi down this path, then perhaps the next few months will be benign and risky assets can outperform. However, we think the risks of an escalation in the currency wars (that have been percolating for several years) is higher than many would like to admit, especially in polite central banking circles.

 So, for moment, we are happy to be bullish the Dollar against the Euro and also selected Asian currencies. As noted above, we have also jumped on board the bullish European equity bandwagon. We will continue to be flexible in our approach as we are not sure how robust the equity rally really is (i.e. we see this as purely a central bank inspired rally that could fizzle out quicker than many expect). Ultimately, we see currencies as the tool of choice for central banks, and this represents opportunities for macro managers in what is likely to be a low return environment interspersed with bouts of volatility.

Stewart Richardson
Chief Investment Officer
RMG Wealth Management