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The investment outlook is about to get murky as we wade into a challenging period for markets. Turbulence from economic activity should start to pick up as the fall-out from the global pandemic monetary liquidity injection starts to rear its ugly head. The compass used to direct investors will also be askew given the distortions in economic data as we emerge from the lockdown as evidenced recently: within the space of a week we have had the biggest downside forecast miss in U.S. employment payroll history against the biggest upside forecast miss in core CPI history. This shows how volatile and challenging it is to get a read on the economy.
Despite the dynamic nature of global financial markets, the one constant over time is the herd-like behaviour of investors to migrate out of risky assets into the sanctuary of the U.S. dollar. At the height of the pandemic crisis last year people were not only panic buying toilet paper, they were also rushing to purchase the Greenback. The intensity of the demand for the U.S. dollar in March 2020 was so great the U.S. Federal Reserve had to step up and assist foreign central banks in their quest for U.S. dollar. This is why it is foolhardy to write-off the benefits of the U.S. dollar in times of market uncertainty – the GFC in 2007 was another period of market stress where investors were rewarded for turning defence into offence with an allocation to a U.S. dollar based product.
We are on alert for a compelling technical bullish signal which is on the cusp of forming in the U.S. dollar and could validate the benefits of the carry in the world of interest rate differentials.
The 'golden cross' is a bullish scenario where the slower moving average (50-day moving average) crosses up through the longer dated moving average (200-day moving average) and depicts a mechanical change in the medium term trend. When it comes to the U.S. dollar, this signal has an exemplary record. Since 1999 the U.S. dollar was higher 13 out of 15 times which can be explained by the trend following nature of the currency markets.
The chart below illustrates previous signals since 2008 and the ensuing rally after the moving averages cross. This signal is close to getting triggered and would cause consternation for the plethora of U.S. dollar bears that exist and would potentially result in a powerful rally, particularly given the crowded positioning in the US dollar.
We still remain of the view that this will be a transitory move in inflation; the downward shock to the economy in 2020 and the subsequent pent-up demand as the economy re-opened has resulted in a much higher than expected April U.S. CPI number. The transient nature of this spike can be assessed from the decomposition of this number – with almost 60% of the month-over-month increase in the headline number made up of just five components. These were used cars, rental cars, lodging, airfares, and take-away food. Once again the devil is in the detail which is why Central Bankers are cognisant that the secular forces should still remain, with the U.S. Fed’s Vice Chair commenting shortly after the release of the April CPI number that an acceleration in U.S. prices will have only transitory effects on underlying inflation.
Commodity prices have also garnered a lot of media attention as speculative buying and bottlenecks from the reopening of economies has resulted in a skew to the upside which is probably not indicative of longer-run price trends. A reversion in commodity prices would also provide some pricing relief and this should also give support for the U.S. dollar given their correlation as well as feeding through to dampen inflation expectations.
The chart below demonstrates the parabolic rally in the Bloomberg Commodity Index following the mountains of liquidity that were poured into the system in 2020 and we are entering a obdurate resistance zone that has capped commodity prices since 2015 which heightens the probabilities that we shall witness a correction in the foreseeable future.
The heightened uncertainty as we continue with an 'uneven' economic recovery, and the spectre of a transitory burst in inflation provides investors with the opportunity to allocate some capital for that left tail risk protection moment. This tends to occur more often than not when financial conditions have become extremely loose and complacency is oozing through the markets.
The combination of the U.S. dollar currency and a rallying high grade global bond market can provide compelling returns in moments of market duress. The first quarter of 2020 is a classic example of this. During this time, the high grade bond unhedged index produced a return of +19.4%, which acted as a strong foil versus the Australian share market, which lost -23.4%. We recognise that not all investors are as dynamically oriented and indeed, may be more ‘long-term policy oriented’ with regards to currency hedging positioning. This episode does underline the point that investors are well able to take control of their currency management and use this as a powerful tool to manage exposures.