Tuesday 29 December 2015
“Fundamental analysis creates what I call a ‘reality gap’ between ‘what should be’ and ‘what is.’ The reality gap makes it extremely difficult to make anything but very long-term predictions that can be difficult to exploit, even if they are correct.”
Commentary & Analysis
Danger Will Robinson it’s forecasting time again & US dollar fence sitting
I realize I am dating myself given the reference to Will Robinson. For those of you too young to remember (or doing something more productive at the time), Will Robinson was the boy hero, or average kid always wondering into some type of bother, from the TV series Lost in Space. Whenever Will got into a real jam, his trusty robot (of the larger vacuum tube variety as seen below) was there to warn Will that indeed there was trouble on the horizon, and in order to avoid disaster and/or serious bodily harm, he should head quickly back to the safety of the spaceship. The robot would spurt: “Danger Will Robinson.” This was Will’s cue to seek cover. Unfortunately we have reached the conspicuous and ubiquitous forecast season; thus, “Danger Will Robinson” seems the proper refrain.
Anyone with even a modicum of experience in markets knows how dangerous this time can be if one’s gullibility quotient is slightly elevated for one reason or another—too much eggnog or good cheer for example. Let’s just review some of the most strident table-pounding forecasts from the cast of pugnacious prognosticators circa late December 2014 as an example of the dangers we face:
1. Interest rates will rise substantially
2. Inflation is just around the corner
3. Oil prices will rebound to $100 a barrel
4. China’s financial crisis is a done deal
5. Stocks will crash
6. The US dollar is doomed
7. Gold will rally to $5,000 on debt implosion around the world
8. A sovereign debt crisis will destroy Japan’s economy as interest rates their soar
You have to love them: Our forecasting heroes may always be wrong, but they are never in doubt.
They are never in doubt thanks to their abiding faith in the broken clock theory of forecasting. So in this vein, let’s just carry over these perennial favorites of our nattering newsletter nabobs for 2016. Hope one comes true; then tell the world how right we were. With the understanding all the bullshit forecasts—previously pontificated—will swirl right down the old memory hole once said “winning forecast” is proficiently promoted across all those discerning distribution channels.
So what is my forecast for the US dollar?
I suspect given my aforementioned and acquired angst with forecasts you wouldn’t be surprised if I don’t play along. Instead, I will share what I believe to be plausible rationales for the US dollar as we head into 2016—rationales that seem equally balanced and will allow for some will committed fence sitting.
Though we all talk about the power of the consensus view, despite whatever analysis we might do, is never quite crystal clear. And when it seemingly becomes crystal clear you can bet there is already a lot of money positioned for a new view to emerge. This is true because the so-called consensus, by its very nature, is the culmination of participants attempting to forecast their own future even though their actions to reality can quickly nullify such forecasts.
Well, given that rather stark attempt to summarize the consensus, what is the current consensus on the US dollar?
In my readings of some of bank analysts from some of the major houses there are two primary and plausible dollar themes in play as we enter 2016:
1) The dollar bull is very much intact, but in the process of a much deserved rest before it catapults to new high ground. The drivers are multi-fold:
a. Rising US yield differential relative to developed market competitors.
b. Relatively stronger US economic growth, part and parcel to “a.” above, i.e. the feedback loop thing.
c. Rising demand for dollars from the emerging world as dollar surplus’ fall and reserves begin to dwindle; with added bonus of corporate balance sheet risk, i.e. borrowing dollars during the commodities boom (in a depreciating currency—the US dollar), which increased both profitability and leverage, becomes a quite painful as the US dollar rallies and aggregate global demand for commodities continues to stagnate. This is not a new theme, but could very much be accelerated in 2016 if global demand does not rebound very soon.
d. Falling surplus among EM and the oil export countries, coupled with rising US rates (at the margin stuff), means less money funneled into risk assets (read stocks). Any correction of “size” in risk assets likely triggers a risk bid into the US dollar.
2) The dollar bull market is over. And the dollar will range for the most part, at best, during 2016. This view stems from:
a. A strong belief in Mr. Market’s discounting prowess, i.e. the Fed hike, and campaign of future hikes, was well signaled, over analyzed, and therefore very much expected by the market; thus all, or at least most, of the good news was already priced into the US dollar. Validation for this can be seen by virtue of the fact the US dollar has not rallied to a new high since the Fed gave dollar bulls exactly what they wanted.
b. Because 71% of the US dollar index weighting is made up of the euro and yen, the dollar may muddle through at best. There is a decent chance we see a dual-market in currencies this year, whereby the euro and yen outperform, while the pound and commodity currencies underperform.
i. Commodity currency performance is of course linked directly to commodities prices over time. Another bad year for the commodities market, which is plausible given global growth concerns, still excess supply of commodities, and plenty of final goods production capacity—not to mention continued labor market slack globally.
ii. Euro outperformance—three reasons here:
1. Eurozone residents sending fewer euro overseas, i.e. buying less foreign debt.
2. Euro banks doing less foreign lending, thus reducing euro supply
3. Euro debt offering declining
4. Euro acts well on risk—de-hedging if you will as funds move money out of euro stock markets
iii. Yen outperformance
1. Yen acts well on risk—and risk is rising for Japan’s economy given latest data, i.e. a three arrow failure?
a. This means a large portion of the massive Japanese capital comes home—repatriation rally.
iv. The pound could be trapped in its own orbit of political risks—EU referendum, soaring current account deficit, and growing expectation in this environment the Bank of England will remain accommodative accordingly into 2017.