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BlueBay's Riley: Further US stimulus may well be on the way

04 August 2020

David Riley, chief investment strategist at BlueBay Asset Management, considers the weakening of the US dollar as a safe-haven asset, the rise in the price of gold and the future of the Fed’s interest rate policy.

By David Riley,

BlueBay Asset Management

The US dollar index has weakened by almost 4 per cent during July to its lowest level since mid-2018 with the euro a big gainer. Not surprisingly calls that this is the beginning of a multi-year dollar bear market are getting louder.

It is true that the pillars of US dollar strength have been eroded by the pandemic. Interest rate and yield differentials with the rest of the world have narrowed; the recent surge in new virus cases has eroded confidence in US growth out-performance in recovery while the outlook for Europe was boosted by the recent agreement on an EU Recovery Fund that we discussed last week.

A weaker dollar is generally a positive signal for global risk assets. It is positive for the S&P 500 as it boosts the foreign earnings of US multinationals. A weaker dollar typically coincides with a pick-up in growth outside of the US and improvement in risk sentiment as witnessed during the global economic rebound in 2017 which was also a period of relative out-performance of emerging market assets.

But while I think the direction of travel is for a weaker dollar especially against the euro and the Chinese renminbi, I don’t think this necessarily marks the beginning of a secular decline in the dollar.

The US dollar remains the global reserve currency and safe-haven asset of choice. The US has contained the virus less effectively than Europe and many countries in Asia, but in several major emerging markets the virus continues to spread and even in Europe, there have been renewed outbreaks notably in Spain. And while Fed rate cuts and quantitative easing (QE) has eroded the carry from dollar assets, yields across developed markets are even lower.

And there is a less positive explanation for recent dollar weakness. The latest bout of dollar weakness has coincided with a sharp decline in US real yields and rising gold price consistent with fears of secular stagnation and currency debasement.

A weaker dollar is consistent with global recovery and reflation, positive for European and emerging market assets. But it also be a signal of yet more monetary stimulus in response to a weakening growth outlook for the world’s most important economy and incipient loss of confidence in the dollar as the global reserve currency.

On the issue of QE and money printing – which is a recurring topic – including in the aftermath of the global financial crisis when there were warnings that rising government debt and QE would result in a surge in inflation. Yet inflation has not only stayed low but been persistently below central banks inflation targets. If inflation were only generated by the combination of government borrowing and central bank liquidity, Japan would be a high inflation economy.

QE is not money printing but essentially allowing the private sector to swap long-dated fixed-rate assets – government bonds – for short-term floating rate deposits – bank reserves at the central bank. This portfolio effect reduces long-term rates and boosts asset valuations. But QE does not directly increase credit to the real economy nor create too much money chasing too few good that would result in rising inflation.

So I am sceptical that this time is different and that QE will end with a surge in inflation. That said, I do think that medium-term inflation expectations are arguably too low and inflation risk premiums should be higher.

I do think the Fed is shifting to an inflationary bias with a focus solely on supporting a recovery in employment and willingness to keep rates ultra-low even if inflation reaches its 2 per cent target. And it is not beyond the realm of possibility that central banks with strong encouragement from governments will accommodate higher inflation to reduce rising debt burdens.

As a real asset priced in dollars, gold is viewed as store of value against higher inflation and a weaker US dollar. As such it is highly correlated to US real yields – the yield on Treasury inflation-protected securities (TIPS). And that has held during with the recent rise in the price of gold.

As a fixed-income investor, the best way to protect against higher than expected inflation is through inflation-linked government bonds or linkers. The coupon on linkers is set in real terms and is fixed, but nominal coupons and repayment of the principal is indexed to inflation.

If inflation is higher than expected, inflation-linked bonds will out-perform nominal government bonds and conversely under-perform if inflation is less than expected. Market-implied inflation expectations are well below central bank targets – with the notable exception of the UK – and for investors who fear meaningfully higher inflation, linkers are attractive despite negative real yields. In the near-term, the pandemic is a deflationary rather than inflationary shock. But the future is uncertain and the damage to portfolios from unexpectedly higher inflation is a risk that investors are wary of ignoring, hence the increased interest in inflation-linked bonds as well as gold.

Finally, there were no changes in policy nor forward guidance from the recent Federal Open Market Committee meeting. The Fed did extend the dollar swap facilities with nine other central banks that played such a critical role in resolving the global dollar liquidity squeeze at the height of the crisis.

And it is worth noting that the day before the meeting ending, the Fed’s various lending and credit facilities were extended from end of September to end of this year.

The Fed statement did for the first time make explicit acknowledgement that the economic outlook depends on the course of the virus.

In the press conference, Fed chair Powell referenced evidence that the spike in cases across much of the US is hindering the re-opening of the economy and emphasized the importance of fiscal policy for sustaining the recovery. He also said that its policy review would be wrapped up soon, setting up an announcement for the Fed’s next policy meeting in September.

Powell was very dovish in the press conference and more stimulus is likely in my view. Probably a combination of revised forward guidance linking any future increase in interest rates to specific targets for unemployment and inflation. The Fed may also shift to an average inflation target whereby it allows a period of above-target inflation to make-up for below-target inflation. The Fed may also increase its asset purchases and shift the balance of its bond holdings to longer-dated securities.

For now, the cycle continues. The continuing adverse economic impact and uncertainty from the pandemic underpins expectations for more monetary and fiscal stimulus, lower real rates, weaker dollar, and rising gold price. This cycle will continue until it is broken by an effective vaccine or a second wave or unexpectedly strong recovery or double-dip recession.

 

David Riley is chief investment strategist at BlueBay Asset Management. The views expressed above are his own and should not be taken as investment advice.

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