|By Matein Khalid| I was surprised by the dovishness of the Federal Reserve’s FOMC policy statement last week given the white hot US labour market and metrics of wage inflation. Hence the $29 rally in gold, the plunge in the Volatility Index to 15, the fall in the US dollar and the surge in oil/mining shares. The Yellen Fed is still worried about deflation risk in China, Europe and Japan, the reason the FOMC statement included two references to “global financial and economic developments”. This is Fedspeak about excessive US dollar strength, which makes sense given the US Dollar Index has risen 25% in the past two years.
The meteoric rise in the US dollar has been devastating for oil/commodities exporting economies and amplified the angst in the high yield debt market, China and the risk of credit contagion. The US Treasury, not the Federal Reserve is responsible for foreign exchange policy. Washington does not want a Plaza Accord style dollar debasement via coordinated central bank intervention. The Fed’s dual mandate does not include the management of the US dollar. Yet the King Dollar trend took the world to the precipice of deflation in 2015, as negative interest rates in Europe and Japan attest.
It is surreal to see the FOMC dialing back its projections for future interest rate hikes in 2016 from four to just two so soon after February job growth was up 242,000, 50,000 above consensus. The Fed has done a mini policy U-turn barely three months after its first interest rate hike in nine years, a concession to Wall Street global risk aversion spasm since January. So it was entirely rational for gold to rise $29 an ounce and the yield on the 2 year US Treasury note plunge from 1.99% to 1.915 after the FOMC statement.
The Yellen Fed made a strategic mistake in waiting too long to raise rates in December 2015 and has now compounded its mistake by glossing over clear evidence of US consumer inflation risk, now 2.3%. It is insane to see Dr. Janet Yellen assert that there will be no 2% inflation till 2018 when the empirical evidence argues the opposite. So much for “data dependence” and central bank political independence! The inflation data simply did not justify a de facto 50 basis point cut in the projected dot plot rate in 2015, the reason the front end and the belly of the US Treasury debt yield curve were just so strong. Policy mistakes by successive chairman of the Federal Reserve (Maestro Greenspan bequeathed us the global credit bubble and his acolyte Ben Bernanke assured us subprime would be contained even as Wall Street banks did their dance of death) led the financial markets to the brink of disaster.
What happens if the March payrolls shows another 240,000 job growth or the inflation data surprises on the upside? Panic in the bond market. The return of the bond market vigilantes of the 1990’s. An “inflation risk premium” in debt markets that tightens financial conditions and devastates the Fed’s credibility, not exactly at new highs even now. Dr. Janet Yellen is clearly behind both the Fed’s inflation – and intellectual curve.
As a financial markets economist and investor, I cannot fathom the policy inconsistencies and mixed messages of the Yellen Fed. How can the most powerful central bank in the world ignore the fastest increase in US core inflation in four years and an unemployment rate that could fall well below 4.8% this summer? How can the Fed leave its economic growth and inflation forecasts unchanged and then slash its (Dot Plot) four projected 2016 rate hikes? How can the Fed argue “proactive”, front loaded anti-deflation insurance when oil has surged 45% and gold has risen almost $200 an ounce in the past two months? Credere is an ancient Latin word means belief and Janet Yellen’s FOMC squandered the credere of the Federal Reserve last week. We will all pay a horrific price for yet another epic Fed policy blunder. Central banks are the last bastion of economic central planning left in the world, apart from the Dear Leader Baby Kim’s North Korean Politburo.
Macro Ideas – What next in the emerging markets bull run?
If ever there was a loser asset class since 2011, it was emerging markets, whose underperformance against developed market indices was epic. Yet I have been a tactical bull on emerging markets for the past month for six reasons. One, Brazil is on a roll, as the 25% rise in the Brazil equity index fund attests. The smart money now believes that President Dilma Rousseff will be impeached by the Supreme Court and forced to resign. The prospect of new elections and a new, reformist pro business government in Brazil (ideally with my old Wharton finance prof Dr. Arminio Fraga as Finance Minister) will mean the mother of all stock market rallies in Brazil. So I track the street protests in Sao Paulo and wonder if Carnival will flash on my Bloomberg screen this spring as the beat of the samba drums gets louder.
Two, the 45% spike in the oil market was the mother of all short covering rallies. As usual, Dubai’s DFM is the highest beta stock market in the GCC, up 28% since its most recent bottom. Three, India’s fiscally prudent Union Budget was a signal to buy Indian banks/consumer shares since RBI Governor Dr. Rajan can now cut the repo rate to 6.5% in April. Four, the Fed, ECB and Bank of Japan are all committed to reflation. When central banks reflate economies, gold rises. Hence the $180 an ounce rally in gold in 2016 and silver, platinum, iron ore, zinc and the Australian dollar have all resurrected from the netherworld. Five, few Fed rate rises and a softer US dollar boosts the greenback indebted emerging markets, notably Turkey, Mexico, India and South Africa. Six, the smoke signals from Premier Li, the Chinese Politburo and the People’s Bank Governor have assured Wall Street that the Middle Kingdom will not use sharp yuan depreciation to export deflation to the world. This halted the meltdown in Shanghai, Shenzhen and Hong Kong.
Of course, all is not hunky dory in the kingdom of Global Macro. Brexit could well lead to end to the European Project and even the UK. The new Cold War with Russia means geopolitical tensions from the Ukraine and the Baltic states to Syria and Turkey. Europe’s money center banks remain in peril due to negative interest rates, opaque balance sheets and undisclosed losses. Mrs. Clinton, Donald Trump and Bernie Sanders all talk tough love on trade protectionism and could well ignite a global trade war. A Chinese banking/credit crisis could abort the embryonic global economic recovery. An “ugly” March payroll number – say, 242,000 like the last month – could make a mockery of the Yellen Fed and send the US dollar and interest rates higher. After all, Fed vice chairman Stan Fischer himself warned the Street about the “first stirrings of inflation” – and ignored his own words when he voted to go dovish at the last FOMC.
I concede that $25 billion has fled emerging markets dedicated funds in the past year, GCC and Russian sovereign credits have been downgraded multiple times and corporate earnings growth is not a given. Valuations are also not as extreme as in January 2016 since the MSCI emerging market index now trades at 11.6 times earnings, still a 25% discount to developed market indices.
With a 0.86 correlation between Brent crude and GCC large cap equities, (it was 0.45 in 2012!) no prizes for guessing the 45% rally in black gold was a steroid shot for regional stock markets. Dubai’s DFM has seen a spike in prices, trading volumes and even retail investor buying. The UAE stock market has also once again become a magnet for bottom fishing offshore value funds.
In the GCC, I believe Oman is deep value. So are China’s H shares and Pakistan. Bank Muscat, the sultanate’s “too big to fail” bank, now trades at a compelling 0.6 times book value at a time when the end of Iran sanctions is imminent. Note that Ominvest shares in Muscat are up 40% from their recent bottom. The smart money is obviously accumulating the Blackstone of Oman!
My strategy call on the Russian rouble at 78 has proven extremely profitable, now that the rouble has soared to 68.4 as I write. The Russian stock market contains at least six double or even triple baggers for 2016, the reason I might spend white nights in St. Petersburg! Indonesian equities have surged 16% for US dollar investors, as the rupiah is the highest beta currency in Southeast Asia.
Currencies – The Canadian dollar strategy idea was a winner!
The Canadian dollar, recommended as a strategic long at 1.46 soared violently from 1.3350 to 1.30 in the two trading sessions after the Fed shock. The loonie has been the beneficiary of the swift rise in oil prices, broad based US dollar selling, a surge in global risk assets as well as the consensus that Prime Minister Justin Trudeau’s first budget will be pro-growth. The risk reversal spreads in the foreign exchange markets suggest that Planet Forex no longer fears major loonie depreciation and is thus not willing to pay excessive put option premia for downside protection. The Canadian dollar bears have been short squeezed by the bulls in the past month as the momentum in the pace of the loonie decline suggests.
I now believe the next pivot level is 1.2840 as the world positions for budget news from Ottawa. The Canadian dollar has accomplished one of the most violent, most profitable (this column was short loonie as it plunged since last September and long once I thought loonie bearishness had turned extreme and irrational at 1.46) bungee jumps in the history of the foreign exchange market. To me, the aesthetics, optics and two way symmetry of this macro idea made it my forex obsession de jour in 2015 and 2016!
The recalibrated FOMC now projects two, not four, rate hikes in 2016. However, I wonder why the Fed had to mention its concern with “global financial and economic statements” not once but twice in its statement on a day that the core US consumer price inflation data showed a rise to 2.3%. The Yellen Fed has, in essence, moved its focus from US data dependence to international financial markets. Post G-20 Shanghai global politics could also explain Dr. Yellen’s bizarre policy shift. After all, a softer US dollar reduces the risks of a global trade war that Trump or Clinton could well ignite in the autumn. Unlike her husband, who authorized the US Treasury’s bailout of Mexico in 1995, midwifed NAFTA and the “strong dollar” policy of his second term, Hilary Clinton could well pressure the Fed to depreciate the US dollar in her quest to win the global currency war. If so, my new 1.28 target on the loonie, a classic petrocurrency, will prove a Sundayschool picnic.
It is now consensus in the world currency markets that the US Dollar Index peaked at its 2015 high at 100. While we trade at 94.6 now after the FOMC, I do not subscribe to this “Peak Dollar” consensus. US macroeconomic and data momentum is for too strong and relative central bank divergence with Tokyo, Frankfurt and yes, Ottawa, must reflect relative economic growth rates, now skewed entirely in the US dollar’s favour, despite its pounding this week.
True, the US Dollar Index has traded/consolidated in a narrow range since its dramatic rise in 2014-early 2015, a chronicle that enabled us to print money shorting the Canadian dollar in the first place, with epic 25% move from my original 1.06 short loonie level. Of course, while currency fundamentals matter most in the end, I would not be surprised if the US Dollar Index now retests August 2015 lows at 92.60, which happens to be a classic 38.3% Fibonacci retracement of the entire King Dollar rally that originally began in May 2014, when Brent was $110, Emaar/GCC equities near their peak and the Canadian dollar deliciously overvalued just below parity. If this August low is violated, I will be forced to write the obituary of King Dollar since the trend is only your friend until the trend comes to an end. The August 2015 lows on the US Dollar Index implies 1.17 on the Euro as the strategic target on this move. Can Dottore Draghi’s monetary bazooka tolerate a strong Euro? No, nien, non and nunca!
Recession risk in the US is a laughable concept, though embedded in Dr. Yellen’s mind. After all, 1Q 2015 growth is on track at the post Lehman 2% trend and the crude oil/inventory drag is no longer a concern. In fact, the Philly Fed now orders strength mean manufacturing PMI’s could well rise and King Dollar is down but not out. Greenback weakness, while acute last week, can easily reverse with a vengeance with March payrolls. It is never prudent to be complacent in global foreign exchange markets.
