There’s been a lot of discussion recently about $ strength preventing risk assets from making new highs. I don’t dispute the fact: it’s obvious we’re losing badly in the battle for competitive devaluation that global central banks have embarked upon. But it’s even worse than the headlines might suggest. Where the real damage is being done is in FX forward markets. In some cases, 12mth $ funding has more than doubled in the last two months alone.
One thing is clear, to refer to this as a “USD bull market” is not correct. As others have correctly pointed out: it’s really a bear market for $ funders. Typically, we’d see this manifest in overnight repo rates, but that’s not really happening. We might also see this show up in LIBOR/OIS spreads (and cross-currency basis) & it has, but to a fairly limited extent.
Where this is showing up instead is in FX forwards. In times of trade war, this is currency krav maga – the art of self-defense as a weaker opponent can gain the upper hand even in the face of seemingly insurmountable odds.
Consider this: since the start of the year, the average 1-year funding cost in EUR, GBP, JPY & CAD has moved by about 30%. Cheaper for those currencies, more expensive for the dollar.
Moreover, it’s showing no signs of stopping. It’s essentially an explosion of the developed markets FX carry trade: borrow in currencies where interest rates are low (or, in many cases, negative), to invest in those countries where yields are high. In order to do that, you need dollars. In the case of each of the 4 currencies listed above, the forward value of the dollar is cheaper than the spot – making the trade that much more attractive. Perhaps this stops when we reach zero, perhaps it just continues.
But that’s not even the biggest move. Beyond the developed markets, the real jump has taken place in just the last month as USDCNH forward points have gone up by more than 2x.
On a trade weighted basis, this is a monster move.
Take the top 10 currencies on a trade weighted basis (I’ll use the Fed’s weights for the sake of comparison).
Consider what the trade weighted $ performance has been in spot space.
Now, overlay what the trade weighted $ performance has been in forward space all-in (spot + forward points).
Bottom line, it’s pretty clear that this $ move is being driven by the forward borrowing cost versus our major trading partners. In a trade war, this is logical self-defense. But the extent of the move is going almost entirely unnoticed since the spot richening of the $ has been “only” 5% over the same time period.
Until the forwards begin to retreat in a meaningful way, it’s only reasonable to presume this move should continue.
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