The Euro, the State of the Bear Market, and the Need for a Stronger USD

IN THIS PUBLICATION:

• A renewed round of QE in Europe might lead to a stronger Euro in the short term.
• We have not seen the end of the first leg of the bear market.
• A stronger US dollar might be the most efficient way for the Fed to weaken consumer demand and reign in inflation.

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Bank of Japan's Yield Curve Control

For many years, Japan has been the world’s laboratory for unorthodox monetary policy. The Bank of Japan (BoJ) has implemented quantitative easing (QE) on a relative scale that dwarfs what the US and Europe have done.

In recent weeks, whilst other central banks have become increasingly hawkish, the BoJ has recommitted itself to its policy of Yield Curve Control (YCC).

• YCC targets a specific level of yield via the purchase of bonds (in this case, the government 10-Year bond), whereas most QE programs purchase a defined amount of assets, without targeting a specific level of yield.
• The BoJ is aiming to keep 10-Year government yields capped at 25 basis points. This appears to be below the level where yields would like to naturally settle.

We can see the impact of Yield Curve Control when we compare the 10-Year yield with 30-Year yield and the 10-Year cash swap rate, which have both moved higher against the 10-Year.

Similarly, we can see the kink in the government curve where 10-Year yields are being depressed by the actions of the BoJ.

During the week ending 17^thJune, 10-Year yields temporarily moved above the 25 basis-point cap, forcing the BoJ to buy a vast number of bonds. On a GDP-adjusted basis, they were purchasing a monthly equivalent of $300 billion, more than three times the level of the Fed’s purchases during its QE regime.

If domestic yields are capped, this distortion should find a release valve via a weaker currency. This is because domestic investors would be selling the Yen and buying currencies where they’ll be able to get higher income. Thus, an aggressive policy of YCC should see the currency of that country weaken.

This has indeed been the case in Japan, where USDJPY has moved above 135, breaking multiple long-term trends in the process.

Many investors, however, are skeptical that the BoJ can maintain yield curve control if inflation continues to pick up.

Higher inflation makes low domestic yields even less attractive, driving more capital into overseas markets. This can create a vicious spiral, further driving down the Yen and creating even more inflationary pressures (i.e. they’re importing inflation by selling Yen and importing goods and services). Additionally, high energy prices exacerbate this issue because Japan needs to import most of its energy requirements.

So far, Japan’s consumer prices (CPI) have remained relatively well behaved. Producer prices, however, have risen sharply and imply further upward pressure on CPI (Producer Prices tend to lead Consumer Prices).

There are two probable outcomes, both of which have significant implications for global assets:

1. The BoJ Remains Committed to YCC: In this scenario, the Yen should weaken further (USDJPY strengthen). It is unlikely that other countries will tolerate the competitive advantage that a weaker Yen would convey to Japan’s exporters. China, for instance, may choose to let the Yuan decline versus the dollar. This could lead investors to find refuge in the US Dollar, driving it higher. A stronger dollar today would tighten global financial conditions, and this would further undermine global risk assets. An extreme version of this scenario was the Asia currency crisis of 1997-98, which had its roots in a period of Yen weakness.

2. The BoJ is forced to Abandon YCC: If yields are allowed to float freely, they should reset to a significantly higher level and probably overshoot because of a loss of central bank credibility. Global bond yields are fungible, and therefore a rise in Japanese yields would push yields in Europe and the US higher too (because, as Japanese yields become more attractive, capital would exit other regions and into Japan, lowering demand for non-Japanese bonds, driving yields higher).

The Yen would probably gap significantly higher (USDJPY lower) as capital repatriates back to the domestic market.

Many investors are already anticipating this move, but the costs of hedging for weaker USDJPY (stronger Yen) have been increasing. Three-month implied volatility on USDJPY is approaching levels last seen during the pandemic.

Whilst downward pressure on the dollar could help improve financial conditions, the rise in global yields would offset this benefit.

The key takeaway is: in both scenarios, the actions of the BoJ could undermine global risk assets, either via a stronger dollar or higher global yields.

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Higher Euro in the Short Term

For many years, the ECB had been trying desperately to generate inflation. Now, however, inflation is running far too hot, and the ECB is planning to hike interest rates as a response to that. German PPI has reached a record +30% year-on-year, and this will probably drive CPI even higher.

Europe’s balancing act is between the need for more stable inflation (through higher interest rates) versus the need to keep bond yields low and stable so that eurozone governments and banks can continue to service their debts.

Italian 10-year yields have already reached their highest level since 2014.

The spread between Italian and German 10-year yields is seen as a barometer of stress (higher Italian yields reflect greater uncertainty about future debt serviceability). These spreads have been widening out, once again raising the specter of fragmentation within the Eurozone.

The ECB has therefore floated the idea of a fund that purchases systemically important bonds, to prevent these spreads from reaching levels which indicate stress.

If the ECB is restarting QE (more selectively this time), then the euro ‘should’ be the release valve and fall relative to other currencies, such as the US dollar.

But in Europe, however, market stability has often been rewarded:

• When the EU finally pulled together its rescue package in mid-2020 and the ECB started to catch up with the Fed’s balance sheet expansion, the Euro rallied versus the US dollar, even though the ECB asset purchases were now more aggressive than the Fed.
• A bond backstop breeds confidence and this, if confirmed, could see the euro rally (instead of falling).

If the ECB successfully launches a support package whilst also raising rates to cap inflation, the initial market reaction could be positive.

Over the longer run, however, a return to QE should depress the Euro relative to the dollar. Many investors are looking for the Euro to reach parity with the US dollar, once the initial optimism has worn off.

The Need for Demand Destruction

Fighting inflation is not just about raising rates. It’s about tightening financial conditions so that demand falls and takes the pressure off prices.

If, however, one of the main drivers of inflation has been constricted supply, then the Fed may need to initiate a greater level of demand destruction so that demand converges on these lower levels of supply.

The Fed’s messaging is often more important than the rate hikes themselves, when managing the market’s rate expectations (remember that financial markets typically price in moves 12-18 months ahead of the present).

When the Fed raised rates by 75 basis points at the June FOMC, this was already reflected in market pricing. The June 2023 Fed Funds future was already implying a higher level of interest rates (close to 4%) ahead of the meeting. The Fed dot plot announced at the June meeting implies a terminal rate (the rate the Fed is targeting for this round of rate hikes) of around 3.4%.

The Fed still has an option to surprise the market at each meeting, but the market has usually done much of the heavy lifting by the time it takes place.

It may, however, need to break something if it wants to cap inflation.

The Fed, like other central banks, has a dilemma. If they reverse course at the first sign of economic weakness, it could encourage another leg higher in inflation.

Currently, they are determined to fight inflation rather than support growth. If the Fed starts to support growth again, before inflation has been capped, then inflation will remain elevated, forcing them to eventually need to tighten further.

But there are signs that some demand destruction may now be taking hold:

• Within commodities, industrial metals often lead. Copper has been consolidating for a few weeks and has recently been testing the lows of this range.

• Commodity currencies have also been weaker in recent sessions. As an oil exporter, we would have expected strength in the Norwegian Krone given oil price action, but it has recently been weaker versus the US dollar.

• The Australian dollar has also been testing the lows of its recent range, reflecting the weaker outlook for copper (a major export commodity for Australia).

• Within equity markets, there’s been a significant pullback in some of the energy names.

Thus, when looking at the next months, we need to remember that a peak in inflation will not be enough for the Fed. They will want monthly inflation to fall to SIGNIFICANTLY lower levels.

The most recent monthly CPI print was 1%. This needs to be closer to 0.3% (3%-3.5% annualized level).

Furthermore, the Fed is not just targeting CPI. It is focusing on food and energy costs, which are two of the main drivers of consumer pain.

Consider this:

• Average levels of US gasoline prices are at record highs. This matters because inflation is felt more keenly by consumers and small businesses than it is by large corporations with hedging capabilities.

• This has been reflected in consumer confidence, which has never been lower than it is today.

• The outlook for small businesses is also at a record low.

Small businesses are bigger employers in the US than large corporations. The consumer is the driving force of the US economy. Small businesses and consumers are suffering because of the impact of inflation. The Fed, therefore, needs to quickly bring it under control and restore stability.

Paradoxically, this will require demand destruction. In capital markets, this is usually marked with a capitulation event (when a large portion of investors throw in the towel and all sell at once)… and whilst equities have been falling, so far there have been very few signs of capitulation.

So what signals should we be looking for to assess if a capitulation event and, thus, demand destruction is taking place?

‘Classic’ Capitulation Event

The fixation on stocks as a barometer of financial health often overlooks the importance of the bond market.

So far this year, the combined losses of bonds and equities are one of the worst on record, capped off by losses within crypto.

These losses will have tightened financial conditions via the hit on consumers, which we can see in the sentiment data.

That said, the bear market is probably far from over:

• Signs of Capitulation: Whilst bear markets often end with a whimper, the first major leg of the bear market rarely does - it usually ends with a capitulation event which we have not yet seen. This implies that the first leg of the bear market is not over.
• Trading Volumes: We should expect to see very high volumes in the first major low of a bear market, marking the point when a critical mass of investors collectively give up on the previous trend. For now, volumes have so far remained subdued.
• Volatility: We should expect volatility to spike closer to the end of the bear market. Currently, the VIX (a measure of implied volatility) is high at 30, but it is not expensive. The S&P500 is moving on an actual volatility of 30 (realized volatility). Fear is when people are paying more for protection (implied volatility) than the market is moving (actual or realized volatility). The VIX should be significantly above actual volatility in a capitulation event.

• Volatility of volatility (VVIX): Vol of vol (what people are willing to pay for ‘options on volatility’) should also be elevated during a capitulation event. VVIX has instead been falling.

• In part, the lower levels of VVIX can be explained by the removal of structurally short volatility players (including the short VIX ETF products) during the events of early 2018 and 2020, but that doesn’t explain the current spike lower.
• Institutional investors have been happy to buy protection at ‘fair value’ (when implied equals realized volatility) and then take profits on their puts when the market falls. This has helped create the ‘orderly’ decline in equity markets over the last few weeks
• Correlation: We should also expect a higher correlation during a capitulation event. This occurs when nearly all assets move in the same direction (down), at the same time, as investors sell their winners to offset losses on their losers.
• We have seen sporadic correlation events, but they have been short-lived and look more like orderly unwinds of multi-asset portfolios, rather than panic deleveraging into a major low.

So, there has been no sign of a capitulation event yet. Meanwhile, consider this:

• The Fed needs to generate demand destruction. Its primary channel for this is via tighter financial conditions. Currently, financial conditions are relatively loose on a historical basis and significantly below the inflation-busting levels of the 1970s.

• Therefore, the Fed needs to break something if financial conditions are to reach the levels required to bring inflation under control.

The main channels through which the Fed can tighten financial conditions are:

• interest rates (short end)
• yields (long end)
• credit spreads (wider)
• the US dollar (stronger)
• equity markets (lower)

Interest rates and bond yields have both moved significantly higher. The rate of change of the move in yields has been spectacular. In percentage terms, many yields have moved at their fastest pace ever, starting from a low base. This may have already tightened financial conditions further than the headline indices suggest (which tend to use absolute levels, rather than the rate of change).

Credit spreads have widened out but are below levels normally associated with recessions. Credit spreads could widen further because of the consequences of slower growth, but it’s unlikely that these will be a primary target for the Fed because that would look like a direct attack on the corporate sector.

The dollar has also moved significantly higher, but so far this has not had much of a tightening effect. Supply constraints have led to commodities also rising with the dollar. This is very unusual as a stronger US dollar usually leads to weaker commodities.

US stocks have entered bear market territory, but they are still (significantly) above the long-term trend. Every time stocks bounce, financial conditions are loosened because it creates a positive wealth effect, increasing the risk of more inflation. The Fed may need equities to fall much further before financial conditions reach sufficiently tight levels.

Over the last couple of decades, the Fed has stepped in when the dollar has risen in a disorderly fashion (too far too fast). A rising dollar can tighten financial conditions, causing global growth to slow.

But that is precisely what the Fed should want today. If the US dollar continues to rise, we shouldn’t expect the Fed to step in and try and cap the move.

If a substantially stronger dollar sees a return to its inverse relationship with commodities (dollar up, commodities down), it could go a long way toward capping current inflation (see the chart of DXY vs Commodities, above).

A stronger US dollar would also help to reduce imported inflation (lowering the cost, in US dollars, of imports) which would help the US economy, especially consumers and small businesses, who are most affected by inflation.

It could still impact the US equity market because large-cap exporters would effectively see their revenues fall. But this might be a worthwhile price to pay for the dollar’s impact on inflation.

Thus, a stronger dollar could be seen as the catalyst for capitulation that will set the first major low of a bear market, generating enough tighter financial conditions to get enough demand destruction to rein in inflation. A stronger dollar might also be a more orderly capitulation event versus the credit, equity, and fixed income alternatives because its impact would reduce inflationary pressures by firstly lowering commodities prices.

Generating a strong dollar won’t be an easy route to tighter financial conditions. But this could be the path of least resistance if:

• Japan is committed to yield curve control and
• Europe is kick-starting a new form of QE to protect its bond market

Both of which, in the longer term, should help drive the US dollar higher.

If given a choice on how best to destroy demand to tame inflation, the Fed would likely choose a stronger US dollar, but it may be the weaker equity market that gets there first.

Thanks for reading through! Obviously, none of this is investment advice.

If you missed our latest crypto update make sure you check it out... Hopefully, it'll help ease the pain.

As always, we'll see you out there...