Morning INR update

The argument between dollar weakness and strength will be most strongly played out in USDJPY as BOJ would remain stern to prevent JPY appreciation unless the two policies converge and a trend emerges.

In continuation to my doubts on US being able to create factory jobs is the dichotomy between US median factory wages and US median household income. US median factory wages is USD 22k per year while median household income is USD 56k. Assume that in a household there are two factory workers the median factory job household income comes to around USD 44 k. Thus with the addition of manufacturing jobs US wages should fall which is a non starter unless degrowth becomes policy. Conversely manufacturing in the US will need increasing wages and higher costs which should be inflationary. Add to this near full employment and the future becomes even more difficult to comprehend. But in the near term Trump’s policies should be inflationary in the US resulting in higher than expected rate hikes and therefore USD strength! But then higher cost products should result in growth peaking out sooner than later, i.e., in the medium term.

USDINR 1m NDF is trading left by 3 p as compared to flat yesterday while KRW has appreciated 0.5% along with mild dollar weakness since yesterday. Equity markets are in the red but the correlation between currencies and equities has become low as dollar policy takes centre stage. Yesterday overnight USDINR traded at 67.75 and with budget tomorrow, euphoria should precede. CMP 67.87, Range 67.95 – 67.72.

How does the US economic supremacy work? US dollar and confidence

How does the US economic supremacy work? US dollar and confidence.

No market view, just a few interpretations.

The world holds more than 60% of  its reserves in USD. That is because oil is traded in USD and consequently most of international trade is done in USD. China manufactures everything and sells in USD and then prevents it’s currency from appreciating, thereby accumulating more US dollar. China then invests these dollars in US treasuries, thereby lending to the customer after realization of sale proceeds. Therefore we can say that the production was done for the Americans and then the money is given to the Americans for safe keeping. Central to this cycle is the world’s confidence in the American political and financial system and the world’s requirement to hold USD for their own credibility.

In India we say that India has received foreign capital in the form of FDI and portfolio flows in a particular year, but then the central bank accumulates reserves (since 2013 at least) and then invests in US treasuries, therefore repatriating the capital back to the US in the form of US government lending. Thus it is just a credit swap wherein the US investor takes the risk of the Indian business succeeding and India takes the safety of the US government not failing.

This story goes around the world and ironically in spite of the US being a developed country and a lower growth country than let’s say an India or a China, the US remains a net receiver of capital from other countries, primarily through central bank reserve holdings. This allows the US to spend, more than the next 10 countries put together, on its defence budget, ensuring a global military supremacy which facilitates the confidence to attract more reserve flows. Making it a cycle (vicious or virtuous, is debatable).

Thus the US is uniquely placed in the world and its growth model is not similar to let’s say a China. China needs to manufacture more to keep its economy going. Manufacturing can grow only if China is able to export, which requires a weaker currency. Since no one lends to China the way they do to the US or since Chinese credit rating would be far lower if it were not for China’s USD 3 trillion + reserves, China needs the US to buy to remain credible. On the other hand the US has reserves of USD 120 bn only showing that it is not dependent on other currencies or assets (like gold) but it is dependent on the world’s confidence in the US dollar and the US machinery.

Thus the US need not be a factory to the world and make its citizens work for 14 hours a day like an Asian economy. Consequently the US is a service economy with 75%+ of the GDP contribution coming from services. The US can continue to maintain a current account deficit (and a wide one) as long as it maintains the reserve currency status. If you have a current account deficit by choice then from a growth perspective it’s important to have a stronger currency (in the GDP equation net exports is negative to the GDP sum or simply the opposite of the Chinese model!). This is what Mnuchin means when he says that a strong US dollar is important for the USA in the longer run. It is an enviable position for any other country as this ability to maintain deficit and still attract capital is what gives the US citizens a higher standard of living with lesser effort, relatively.

On the other hand a weaker dollar reduces the ability of the American consumer to spend and takes the inflation higher. A higher inflation is like a spanner in the growth wheel and rate hikes would soon follow to prevent the economy from growing. A weaker dollar after a point would also indicate reducing confidence in the American system which is counterproductive to attracting capital or the existing reserve holders who would start panicking.

With confidence going down in the EU post Brexit and before the 2017 elections in Netherlands, France and Germany (may be Italy too), the reserve currency status of the USD is stronger than it has been in the last decade. China doesn’t have the political fabric that (in my view) is a pre requisite to attract the same quantum of reserve currency allocation like the USD or even the Euro for that matter.

Thus at least in the visible future it’s unlikely that the US model changes and unlikely that the US makes its citizens work in factories when they need not. One President might feel so citing jobs as a problem (that’s an easily sellable problem), but the fact is that US is near full employment and has added more than 2 million jobs per year for the last 3 years with a strengthening dollar!

Weaker dollar outlook and the conflicting realities

Weaker dollar outlook and the conflicting realities

 

How quickly the market shifted from a stronger dollar outlook to a weaker one (basis Donald Trump’s statements) is surprising. A lot still needs to be answered before the weaker dollar strategy fits into all aspects related to the current US and world economy. This note is to express those doubts.  

 

The interest rate differential between the US and Europe or US and Japan remains and is set to widen as US seems to be on a rate hike path while ECB and Japan still talk about supporting their respective economies with monetary easing. How this widening interest rate differential (a manifestation of the growth differential itself or loosely the inflation differential too) fits into a weaker dollar strategy, is something that still needs to be answered.

 

A higher fiscal deficit would increase the supply of bonds and push yields higher in the US which would attract more investments into the reserve currency (USD) as other reserve currencies (EUR, JPY, CHF) struggle to generate yields or are not as stable in the current environment (GBP). The higher fiscal deficit should again result in higher growth, higher inflation therefore higher interest rates. This in turn will fail to fit into a weaker dollar strategy.

 

If there are tax incentives given by Trump (like Homeland Investment Act) to get investment into the US, then the quantum of funds moving on shore could be higher than USD 1 trillion according to the lowest estimates. Thus again a weaker dollar outlook doesn’t gel in with this assumption of attracting funds on shore.

 

In summary a weaker dollar strategy doesn’t fit in with a stronger US economy as compared to a weak Europe and Japan. Thus a weaker dollar can only be achieved with huge intervention by the FED which should again be inflationary increasing the Fed’s balance sheet size. The FED has total FX reserves of USD 118 bn with currencies only adding up to  USD 39 bn as of November 2016. Thus the current ability of the Fed to intervene decisively in the FX markets seems limited unless it decides increase its balance sheet size again.Verbal interventions or tweets by Trump would only go as far (perhaps 5%) to keep the dollar appreciation in check against fundamentals.

 

Generally USD strength or weakness is not so much determined by trade as it is by capital movement globally. USD is the world’s reserve currency and in the current environment no central bank would be keen to shift reserves from USD to EUR or JPY given the lack of yields plus the uncertainty surrounding the EU in 2017. For Trump to achieve a weaker dollar is going to be difficult task given the current growth and inflation differential between the US and other DMs.

 

Possibilities are that a weaker USD strategy is aimed at China (his statement was aimed specifically at China) which can be achieved basis bilateral talks and the rest of the market functions the way it efficiently was basis the assumptions on US growth and fiscal deficit post Trump elections.

 

Too soon to form a view without all questions answered. I would see a weekly closing below 99.5 on the dollar index as a confirmation of an approaching dollar weakness. Meanwhile we can continue to expect dollar trades to surprise us on with conflicting themes.