Summer 2015 Part One: Long Dollar

I’m sitting in a long US dollar currency play against the New Zealand dollar that I must admit has been very good to me of recent. The position is one that I’ve been leaning against whenever I saw any short-term (intraday) inclinations of the dollar appreciating. Well more and more, over the past few weeks, I’ve been finding less and less short US dollar trades in my usual hunting grounds against the Australian dollar, the Euro, and the Pound Sterling. It was to the point that I had to start re-evaluating my short- bias stance on the US dollar. I started my search for fractal patterns that clearly repeated themselves in my shorter-timed charts, and the corresponding nascent stages of those same patterns in my longer-timed charts. At the same time I start parsing through the news headlines as the data statistics roll out for signs of an overall change in the sentiment of the numbers. As of now, (backward looking) economic statistics are still showing ‘slow and steady’ progress with US economic growth, and by extent, the rest of the world. 

The dollar has had a fairly extended period of steady gains against most major trade partners. This has been supported by the air of uncertainty that has lingered over the global economy since the recovery began back in late 2009. Most recently, I have stepped forward and called for a reversal of the dollar’s upward trend. This idea was being supported by the relative improvement in US economic data versus that of most trade counterparts, and the implications the Federal Reserve were telegraphing for monetary policy. The most recent development in the narrative is the perceived influence that financial market risk, global economic sentiment ex-US, and international institutions like the International Monetary Fund have over US monetary policy. This latest layer of complexity suggests that there are more elements of uncertainty in global financial considerations, and so more reason for investors to proceed with caution.

The investment portfolio implication is renewed support for a long US dollar bias. Not necessarily because of American economic outperformance, but because the US dollar is a relatively safe asset to hold over time. The same can be said for most other safe haven assets like the Japanese Yen and the Swiss Franc. The exception being gold; as inflation expectations remain well anchored in the US and across most of the developed world, and because it behaves more like a commodity rather than a hedge for financial uncertainty at this juncture. Equities should benefit in the medium term as easy monetary policy at most major central banks continue to depress interest rates, and by virtue the rates at which future cash flows of companies are discounted by to generate current stock prices.

I was right (this time)

If  you went short dollar when I said to go short dollar, then you would have made money. If not you didn't. Keep reading, keep trading, keep making money.

The Tale of the Output Gap

The output gap, is a seldom mentioned economic statistic compared to some more readily recognizable ones like Gross Domestic Product (GDP) or Consumer Price Index (CPI), yet its implications have just as much sway over monetary policy as its better-known cohorts.

The output gap is defined as the difference between the actual output measured in GDP, and the potential output of the economy at full employment without evidence of inflationary pressure. A positive output gap refers to a period where the economy is producing above its long-term potential, and positive inflationary pressure is evident in the economy. A negative output gap refers to a period in which the economy is producing below its long-term potential, and negative inflationary pressure is evident in the economy. The Great Recession, was not the first period in American economic history where the output gap was negative, though it does stand out for its duration compared to other recessions. When it’s all said and done, the US output gap is likely to drift back into positive territory to offset the current period of a negative gap. I am interested more specifically in the overall trend unfolding in the time series of the output gap statistic.

 

After a short glance at the time series going back to 1949 of Output Gap data, a downward trend becomes apparent. My intuitive conclusion is that the American economy has been progressively falling behind its long-term potential for output, over the past 65+ years. This timeline coincides with the lifecycle of the Baby Boomer generation. In other words, the Industrial Revolution that occurred in the US economy leading up to the Great Depression, set the bar so high for relative expansion of production potential, that the following generation spent the sum of its working years perniciously falling short on the whole. Not to be understated, this is the generation that built on decades of industrialization to create what we now consider the difference between developed and developing economies. As a final act, the Baby Boomer generation facilitated the transition from the manufacturing centric economies of their boom years, to the service centric economies the developed world enjoys today.

The next Act is set to be as spectacular as, if not more so than, the previous Acts of the Industrial Revolution and the post World War 2 manufacturing boom seen in the developed world. The next Act is the story of the Millenials and a service driven economy that does not place a premium on labor. The x-factor in this part of the narrative is how integrated and extensive the role of technology will be in the resounding success, or epic failure of the next generation to ‘have a turn’. To the credit of the Millenials, technology is an incumbent part of their everyday existence, and integration of ideas both abstract and mundane, is second nature. The frontier of human-technology interfacing may prove to be ground upon which this next generation of entrepreneurs and problem solvers cultivates the next burst of economic expansion.

 

All Good Things Must Come to an End

I’ve based most, if not all of my investment decisions around the performance and perceived outlook of the US dollar. It has certainly been a fairly consistent marker of global risk appetite versus risk aversion for as far back as I can compare financial data with the macro-economic narrative of the day. I have recently completed a full turnaround of my foreign exchange portfolio from net long dollar to net short dollar. The trading decision to turn the portfolio around was based on technical signals from my charting software, and the analysis it allows me to perform of the prices of my preferred securities. The conviction to initiate and follow through with the reversal comes from a compilation of my interpretation of my trading signals, and the evolving macro-economic environment.

My technical analysis of the price movements of a few dollar exchange rates have highlighted several consistencies with some trading signals and the directional magnitude of the market outcome of macroeconomic data and information. Though the individual currencies in the portfolio paint their own pictures of their respective economies on the ground relative to the dollar, the index acts like a weighted average for comparison. This average represents the sum of all greed and fear in international capital markets. In a nutshell, as of recently, the signals that I have been interpreting from my technical analysis have all been pointing to international capital markets that are finding fewer and fewer reasons to be fearful of the near-term macroeconomic environment. With this easing of sentiment, the dollar will lose its allure as a safe-haven in exchange for rising foreign yields.

The picture painted by my technical analysis of my charts tends to coincide with the macroeconomic narrative that the Federal Reserve and most market commentators seem to subscribe to. It is worth mentioning that as before, the mistiming of a macroeconomic insight and a financial market decision making has left me needing to actively manage my hedging efforts while I wait for the rest of the party goers to realize the festivities are over.

While We Wait

The US dollar is accepted practically everywhere, and is used more than any other currency for international transactions. The US economy by most measures is still the largest and most productive economy on earth. This puts the United States in an interesting position; some might say dilemma.

When the US economy was growing at its potential and the dollar was falling, a large portion of exports generated in emerging and developing markets were either meant to be sold in the US, or processed elsewhere before being sold in the US. Inversely, those same exporters were the ones consuming the technology and intellectual property being exported by the United States. But as it currently stands, the US economy is rehabilitating from the traumatic effects of the 2008 Global Financial Crisis and resulting economic spillover. Meanwhile the dollar has been rising almost vertically for the last five years or so. This recent trend in the dollar translates to a general level of unease - - not necessarily fear - - in international financial markets. US economic data have been overall positive and improving. But with the demographic shifts that are beginning to accelerate in developed economies, along with already monumental levels of private and public debt, sources and drivers of sustainable growth are few and far between. That being said, historically the safest place has been the US dollar in times of economic uncertainty.

The current consensus is that this summer, conditions will be ideal for the Federal Reserve to begin re-adjusting its stance on loose monetary policy. This will undoubtedly be a significant signal from the Fed to US and global financial markets that the economy is once again growing on a sustainable path that can lead to a zero output gap. This signal will inevitably filter into foreign money markets and interest rates will adjust in other economies closely linked to the US. Once local prices adjust, in response to inherent sensitivity to funding costs, monetary policy in other major economies will begin to re-align as well. This scenario plays out if the signal from the Fed is reinforced by subsequent steps towards further policy tightening. This of course, can only happen if the US economy is once again growing on a sustainable path that can lead to a zero output gap.

In the meantime the dollar is beginning to consolidate, and somewhere out there, investors are positioning their portfolios for long anticipated news from the Fed on how the US economy is really doing via monetary policy signals. The Fed, in turn is waiting on signals in the economic data to discern the future of monetary policy; and in the real world, people go about their daily lives.

Not Quite Like Before: The Dollar and the US Economy at Odds

 The dollar is currently rising through levels not seen since the mid to late 1990s. That of course was a time of great optimism, inspired by a wave of economic development and expansion, not just in the US but across the globe as a whole. Since then we’ve seen the dollar peak and drop to lows made just prior to the onset of the Global Financial Crisis of 2008. Along the way, the tech bubble burst, the housing bubble burst, and finally the commodity bubble burst. The bubbles themselves representing the peak of the dollar, the accelerated decline, and reversal respectively over time. Now, the dollar is once again appreciating steadily versus the currencies of US trading partners.

On the surface, this looks like the US economy is standing out as a place where an investor can earn a reasonable return when adjusted for risk, as was possible in the late 1990s. With a few details missing this time of course. For starters, the economy is just not growing with the same enthusiasm as it did back then. Unemployment is not providing upward support for wages and consumption now as it did in the 1990s, while short and medium term inflation in not expanding providing support for interest rates and monetary. This much being obvious, the financial markets have been able to steady the course to higher prices for both stocks and bonds. Albeit, a sizable chunk of the financial asset price increases can be attributed to the mechanical requirements of administering the Federal Reserve’s Quantitative Easing programs by the Federal Open Market Committee (FOMC), the remainder can be attributed to investors underpricing risks of future price decreases by continuing to transact at the elevated price levels.

As with most aspects of human existence, this too is unsustainable. The complexity of the moving parts that influence the macroeconomic, and monetary equilibrium of an economy like that of the United States will undoubtedly continue to make deciphering a clear narrative a daunting task.

What Really Happens to Asset Prices?

If you subscribe to the conventional dialog about the normalization of monetary policy by the Federal Reserve, the so-called ‘lift-off’ should be this summer or thereabouts. I’m not necessarily convinced that the timing is best, but I digress. The primary result of the Quantitative Easing programs utilized by the Federal Reserve was an enormous increase in excess reserves in the banking system. A secondary effect was the run-up in financial asset prices, as a result of the open market actions of the Fed to influence the levels of long-term interest rates. Economic Commentaries from the Federal Reserve Bank of Cleveland suggest that the target of Fed tightening will be the excess reserves within the banking system, and not necessarily interest rates from the onset.

When the vast amounts of liquidity that the banks hold starts to collectively dry up due to the change in the Federal Reserve’s stance on monetary policy, the transactions that have been supporting financial asset prices will begin to slow. At that point, what happens to asset prices? Equities prices on one hand, are at record highs and likely to drift higher. Without the technical demand from the banking system, the fundamental demand in relation to household savings levels will not be enough to keep equity prices at or above current levels.  Debt prices on the other hand, are at record highs and likely to drift higher. It is important to note, that the rebalancing effects of the Federal Open Market Committee’s (FOMC) actions in the debt markets to influence long-term interest rates pushed bond prices to now elevated levels.

Quantitative Easing was a necessary evil on the part of the Federal Reserve, as doing nothing would have been even less palatable. Now, we’ve arrived to the point of dealing with the aftermath and eventual unwinding of the policies. Without the implicit and at some points explicit support of the Federal Reserve, financial markets in the US and by extension the rest of the world would be forced to stop pretending. A more realistic picture of the economy may have a chance of emerging. Monetary policy unwinding does not necessarily turn into a market crash, it would simply effect a realignment of Wall Street with Main Street.