A Few Thoughts from Asian Business Trip

Sometimes the mountain looks clearer from the plain the summit to paraphrase a American-Lebanese poet.   The dollar appears to have entered a new phase on May 3.  On that day, it reversed higher against the euro, yen, and sterling for lows not seen in a while.    

It is tempting to construct a fundamental narrative for the change.  However, the usual drivers are noticeable by their absence.  The US economic data has been mixed, including the employment report that often sets the tone for the monthly data cycle.  The US 2-year premium over German is flat over this period and about 10 bp smaller over the past fortnight.  The US 10-year premium over Japan has narrowed eight basis points since May 3.   

Neither inflation expectations nor investors expectations for the June FOMC meeting have changed.  The 10-year breakeven inflation rate has fallen four basis points to 1.60% since May 3.   The implied yield of the June Fed funds futures contract has slipped a single basis point.  

The hypothesis the dollar's resilience is a function of positioning rather than fundamental developments has broader explanatory power.  Given the extreme positioning the futures market of the euro and yen bulls (gross positioning) relative to speculative positioning in sterling, helps explain why sterling is the strongest of the majors since May 3, falling only 0.6% against the greenback.  

Similarly, it also explains why the yen is the weakest of the majors.  Judging from the speculative positioning in the futures market that was the most extreme position.  Japanese officials threaten intervention and the yen still strengthens.  Japanese officials threaten intervention and the yen weakens.  Was the threat of intervention the driver the dollar's bounce? 

Some of those that subscribe to the currency war narrative have been warning since mid-February of BOJ intervention.  It has not materialized.  Some observers imagined a secret protocol in late-February to all the dollar to weaken, which ostensibly made intervention more difficult. However, officials have consistently warned that Japan reserves the right to intervene in disorderly and one-way markets.   

Intervention is an escalation ladder.  There are various expression of concern.  Material intervention is a high rung on the ladder.   There is a risk, it seem, that too many observers see verbal intervention as a prelude to material intervention.  However, climbing sequentially may undermine the effectiveness of actual intervention.  Verbal intervention can be effective if it is a signal of credible material intervention or a policy change.  

Technically, the low the dollar made against the yen after the BOJ chose not to expand policy at the end of last month, was not confirmed by technical indicators.  This warned of the risk of a short covering dollar rally.  The dollar's bounce of  2.25% against the yen since May 3 reduces whatever chances there were for intervention.  

We still argue the bar to intervention is high.  Japan diplomatic style is inclined to make concessions before a G7 summit to avoid criticism.  The same modus operandi makes it reluctant to intervene before the G7 meeting and summit later this month.    Moreover, these seemingly technical dollar bounces breaks the appearance of one-way or disorderly markets.   

Turning to the eurozone, the three largest members reported weaker than expected March industrial production figures today.   Germany and France reported declines for the second consecutive month.  The 1.3% decline in Germany was twice February’s fall, and the median forecast was for 0.2% slippage. France was expected to report a 0.7% increase. Instead, industrial output fell 0.3%.  Italy's flat showing compared with expectations for a 0.2% decline.  

One implication of this is that Q1 GDP is likely to be revised down to 0.5% later this week from 0.6%.  It may not be a big deal, but the pace of growth in the eurozone may have peaked in Q1, where it surpassed the pre-crisis level of output.  

There is no immediate implication for ECB policy.   All the ECB's initiatives have not been implemented.  The results have to be monitored for some time, which helps explain why there is typically a lag between ECB moves.  Contrary to the secret Shanghai agreement talk, we suspect that many in Europe would actually prefer a stronger dollar. 

One of the most interesting lines of reasoning picked up in Beijing was that many investors there would see Brexit as a sign of US weakness.  Discussions Brexit typically focus on the implications for the UK and Europe.  The US has long favored an integrated Europe, and contrary to some press reports, it was not simply covert operation.  US leaders have understood a strong Europe was in the US interest and used various policy tools, carrots, and sticks, to facilitate it. 

President Obama's trip to London and his remarks about Brexit (in sharp contrast to Trump's suggestion that Britain would be better offer outside of the EU) was understood by many as the US trying to get a client state to do what it wanted.  Brexit would be seen as a sign that US power is waning.    

Of course, we are not in a position to judge whether this assessment goes to the upper echelons of Chinese government and the Communist Party.  However, the state-centric narratives are popular in China as it is true to their experience.  It is also consistent with Chinese officials criticism of what is sees as the instability of an American unipolar world.  Attempts to provide examples of the world not being unipolar knocked aside.  Developments like North Korea possessing nuclear weapons, as does Pakistan (and several other countries that the US probably wishes did not have them), losing the Vietnam War, or Russia annexing Crimea, and Castro's tenure in Cuba, to name a few, are deflected as a ploy to play down the extent of US power. 

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