The US dollar is still the center of gravity

In the Saxo Bank forecast for the second quarter, written in March, during the worst panic on the market, I maintained that "It is impossible to set the bottom in the markets or the peak of the crisis until the dollar trajectory returns". In retrospect, you can see that this just happened thanks to mobilization through Fed terrifying amounts of liquidity and the mix of asset purchase and loan programs.

In fact, on March 23, simultaneously the dollar peaked and most of the world's stock indices hit a low. Since then, in order to extinguish the fire, ie the contagion effect, central banks have provided markets with an ocean of liquidity and the USD has returned to its pre-crisis range.

About the Author

John Hardy director of currency markets strategy, Saxo Bank. Joined the group Saxo Bank in 2002 It focuses on providing strategies and analyzes on the currency market in line with macroeconomic fundamentals and technical changes. Hardy won several awards for his work and was recognized as the most effective 12-month forecaster in 2015 among over 30 regular associates of FX Week. His currency market column is often cited and he is a regular guest and commentator on television, including CNBC and Bloomberg.

Now, with the start of QXNUMX, the question arises whether the March nadir in the market and the impressive rebound that followed was not both the beginning and the end of the cycle, which would mean that we are moving towards something that might resemble normal. In our opinion, this is unlikely. In the introduction to forecasts for this quarter Steven Jakobsen describes how our response to the crisis shuts off the possibility of any dynamic recovery. The reactionary policy of central banks consisting in saving practically everything leads to zombification, and the national policy shift accelerates our course towards deglobalization.

Yes, we've finished a cycle in a sense. A huge rise in share prices - and other risky assets - as well as strategy pump and dump in relation to the dollar, these are products of high liquidity, the amplitude of which has reached its maximum. At this point, the pace of support for the economy and markets will only increase as we reach the next stage of a deep crisis. QXNUMX will see new themes on global markets and currencies, beyond the bizarre swings in risk appetite that QXNUMX saw in response to liquidity injections from global monetary policy makers.

Liquidity and solvency

First of all, there is the solvency problem, which is much more complicated in the context of the consequences of a shock to the economy than substantial liquidity or systemic risk. The economic recovery in the coming quarter and later is unlikely to resemble a V-shaped recovery regarding liquidity and risk appetite as a result of an explosion in central bank balance sheets.

This most likely means that the volatility in the coming quarter will be even more two-way than in Q750, and the US dollar - and the Japanese yen - are not yet ready for a turnaround, at least not for a sustained turnaround. Volatility will be the product of the usual cycle of recession-related insolvencies, with higher risk this time due to last cycle's excesses. QXNUMX has already seen a record number of corporate bankruptcies, which is a significant problem for the Fed. It can buy corporate bonds - worth USD XNUMX billion - but it cannot prevent a company from going bankrupt in order to restructure its debt.

Perhaps Q1934 is still too early, but ultimately the USD has to make a comeback. One of the reasons is that we live in a world drowning in dollar-denominated debt, both within the US and globally - and any sustained recovery must result in a devaluation of the USD in real terms in the US and in relative and real terms (exchange rates ) in the rest of the world. The risk of an increase in insolvencies and bankruptcies will lead to direct devaluation on a scale not seen since the devaluation of debt after the end of World War II or the entry into force of the US Gold Reserve Act of 20. In the latter case, the US government lowered the value of the USD from USD 35 to USD XNUMX per ounce of gold.

The main unknown concerns the time horizon, but the pressure in this regard will increase in QXNUMX. Ultimately, devaluation will occur as a result of the broadly understood loss of independence by the Fed. How? By imposing caps on yields or some other form of yield curve control to ensure that fiscal spending is not constrained by considerations of whether the "market" will be able to absorb ordinary Treasury issuance used to fund spending.

The presidential election in the United States will weigh on the future of USD and global markets

As a result of President Trump's mismanagement of both the Covid-19 crisis and the George Floyd anti-racist protest crisis, Donald Trump has lost support among the electorate to Democrat Joe Biden. The changing of the guard in American politics is often a key moment for financial markets due to changes in taxation and other policy areas. With fiscal primacy and the gradual loss of independence by central banks, and with all indications that the Democrats will take over both chambers of Congress, the 2020 election could be just as groundbreaking as the 2016 election.

We will devote more time to this topic in the forecast for the next quarter, but over the next three months tensions will increase and significantly slow down the appreciation of the USD. A Biden presidency could mean tax increases, a climate program, minimum wages and other policies that hit corporations and the relative attractiveness of US assets. Even the fact that the Biden administration will seek to increase spending on infrastructure, health care and other areas that would increase inflation will not change this.

Exchange rate volatility will increase as a result of currency wars and fiscal primacy

The Fed and world central banks managed to win the first round by pushing up asset prices and avoiding direct repercussions on asset markets. Ultimately - most likely in the fourth quarter after the presidential election - de facto they will lose their independence due to the transition to Modern Monetary Theory (NTM) or a similar system based on fiscal primacy. Such a regime will aim to increase nominal growth at all costs to prevent an increase in the debt burden in real terms – in short, financial repression. This will benefit hard assets, commodities and some equities, while fixed income investments will suffer.

In the currency context, the currencies of countries using the largest financial repression and the most aggressive NTM programs will be lost. Economies with significant raw material potential will be relatively successful. Current account issues will increase in importance due to deglobalization, slowdown in trade and possible decrease in capital flows.

Many of these issues will become part of the market narrative and reality after the end of the coming quarter, with QXNUMX most likely turning out to be a transitional period. This can be ruled out only by a clear increase in support for Biden in the polls, which would make it easier to predict the outcome of the election. Whenever possible, markets prefer to rely on predictions rather than on the current state of affairs.

In addition to the emphasis on the USD exchange rate, the third quarter will show whether the EU has sufficient solidarity to avoid another round of existential problems. In QXNUMX, the signals were more promising than expected after German Chancellor Angela Merkel changed her approach and agreed to a greater exposure of Germany's balance sheet to EU-wide spending.

However, the reaction of the EU budget seems modest and delayed in the context of the scale of the crisis, therefore these promising signals should be significantly strengthened in QXNUMX. Long-term concerns about a new existential crisis in the EU can only be alleviated by reducing disparities within the Union and by clearer signs of solidarity.

First of all, given how wrong the consensus on the shape of the market recovery in QXNUMX turned out to be, it is important to be open with regard to developments in QXNUMX, taking into account the risk that the liquidity response was so excessive that The Fed has created another speculative bubble. Be careful.