New article from Tatton Investment Management: Ominous US-Dollar strength

30 September 2019

The unprecedented events unfolding in UK politics this week will have distracted many UK investors from developments in the wider world. But those global developments may well carry far greater significance for near-term return developments than the latest ructions in Westminster.

One of the week’s most notable trends has been the strength of the US$. The dollar has gained around 1.2% against the €-Euro since the end of last week alone, and a similar amount against most other major currencies (with the notable exception of the Japanese ¥en). That strength is a continuation of what we have we seen since the beginning of the year: the US$ index – measuring the dollar against a basket of other currencies – is up over 3% since the start of 2019. And it comes despite the fact that the Federal Reserve has cut its interest rate twice this year already (which, all else being equal, should draw capital away from the US).
 

The strength over the year despite the Fed’s rate cuts is likely a reflection of markets’ sentiment on the global economy, which has slowed more markedly than the US economy. But the recent bump-up could be an even more worrying sign. A great deal of global financing is done in dollars, so when companies need to service or rollover their debt, it leads to greater demand for the currency. In times of stress – when refinancing debt becomes difficult as lenders are unwilling to extend credit – struggling businesses or banks may be forced to buy dollars to cover their positions, rather than borrow.

That feeds into one of our observations and articles of last week: the unexpected spike in US repo rates. We wrote that the spike in the rate at which banks borrow from one another could well be a sign of stress in the US or global financial system, as the Fed was unable to meet the short-term cash requirements of financial institutions. Many commentators put the episode down to quirks in the financial system: important tax dates in the US, a reduced Fed balance sheet and a swathe of new US treasury bonds needing to be absorbed by the market.

But it was enough for the Fed to decide they needed to intervene, by injecting considerable amounts of liquidity through their open market operations. The crucial thing to note now is that those operations have had to continue through to this week. And what’s more, they have been oversubscribed nearly every day. This suggests that the need for dollars is even greater than it looked last week – that there really is stress in the financial system after all.

These episodes usually happen when one or several financial institutions face significant pressure. And as we wrote last week, the culprits may well be in China, not the US. The difficulties that Chinese banks are facing are clear to see – with the government’s deleveraging efforts and the country’s increasingly severe economic slowdown putting them under strain. Defaults or government takeovers among the smaller regional banks are becoming more common. If anyone is in dire need of short-term funding, it is likely to be them.

But even so, the explanation might not be so frightening after all. Next week is China’s national day – marking the 70th anniversary of the establishment of the People’s Republic. The country is set for an extended holiday break, meaning that the business and financial timetable for this week is similar to what we experienced at the end of the year. It could be that banks need to cover their positions before the extended break and that, once the holiday is over, things will return to normal. But we will not know until next week or the week after. Seeing how things develop in that time will be crucial.

For now, we will have to catalogue it with the other distress signals in the economy. One of the most notable of those is the worrying rise in company defaults and financial difficulties. A number of high-profile stories have emerged recently, from the collapse of holidaymaker Thomas Cook to WeWork’s IPO being put on ice (and, this week, their celebrity CEO Adam Neumann being fired). According to certain reports, even luxury carmaker Aston Martin is facing severe problems, with rumours swirling of an upcoming default. All these companies have their own reasons for coming under pressure, but we should be acutely aware of how quickly specific problems can snowball into economy-wide ones – particularly at a time when markets are scrambling for dollar funding.

Worse still is that these issues are playing out against a backdrop of less-than-stellar economic data. This week’s drop off in PMIs (measuring business sentiment) for the services sector suggests that the previous struggles in manufacturing may be spreading and impacting consumer sentiment. The underlying economic troubles should not be overstated, but they do suggest fragility, where a shock, financial or otherwise, could tip the balance into negative territory.

That is why policy is now in focus more than ever. Monetary policy on its own seems to have exhausted its effectiveness – as now publicly acknowledged by central bankers themselves. A boost from fiscal or trade policy is now needed more than ever if the global economy is to get back on track. In the UK, that would be some form of Brexit resolution – and preferably a good one. On that, we cannot say much more than has already been said by others: what happens will depend on the outcome of an election that now looks inevitable, where either a Conservative or Labour-led coalition government seems the most likely result.

For the rest of the world, the focus is much more on Donald Trump’s trade wars. A trade deal being struck between the US and China could be just the thing needed to pull up business and market sentiment – to the benefit of the global economy. So, we take heart in the positive signs coming from Beijing, as well as the pre-agreement of a trade deal between the US and Japan. But it is not all good news: how the impeachment procedure against President Trump and upcoming military demonstrations in China will affect negotiations is hard to say. 
 

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