The Forest for the Trees founder and Chief investment Officer Luke Gromen has been one of the longest-standing dollar bears on Wall Street, which is really saying something these days, given the greenback’s short-squeeze inspired rally, which has driven the US currency higher since late March. The buck’s recent move higher is the first sign that the greenback’s multiyear bear market has finally ended. Looking ahead to the second half of 2018, Gromen says his firm has embraced a “tactical shift” in its short-term dollar positioning as it anticipates what it believes will be a “two-part” trade during the next year.
At the heart of Gromen’s USD strategy is the notion that a widening US fiscal deficit has become a front-and-center concern for FX traders for the first time in their career. The problem, Gromen explained, is that the Federal Reserve is bumping up against the limitations of what Gromen calls the “impossible trilemma” of developed market countries.
As Gromen explains, in Q4 2016, once deficits began widening again as a percent of US GDP again, the US has started grappling with its own version of the EM impossible trilemma, the notion that the Fed can only stomach two of the following three trends concurrently. In February, the 10-year yield spiked as US stocks sold off, something that Gromen believes spooked the Fed.
So, as we came into 2018, we thought we were going to see more of what we saw in 2017, what we just described in terms of the widening deficit. In 2017 the US saw a falling dollar, rising stock prices, rising short-term rates. And as we came into 2018, we thought this combination of the US impossible trilemma would continue.
That was until the long end of the Treasury curve sold off in February’s equity market selloff. And we think that was an event that really spooked the Fed. It caught our attention. And that was really when we started to shift our view near-term tactically on the dollar.
All three are periods of time when the S&P 500 sold off 10% in a relatively short period of time. The S&P in each chart is in blue. 10-year Treasury yields in each chart are in red. In 2010: stocks down, 10-year yields down. IN 2015: stocks down 10%, 10-year yields down big. In 2018 you can see a very different pattern, which was that stocks fell 10% – one of the fastest 10% selloffs in history – and yet 10-year yields were up. The long bond sold off on a very sharp US equity selloff. For us, that was a big moment.
Looking back, episodes where the deficit widened as a percent of GDP occurred seven times in history. Six of those prior widenings were followed by a US recession within 12 to 14 months. The one time it did not was in the mid-‘80s when the dollar was significantly devalued at the Plaza Accord. The reason for these shifts, Gromen argues, is that central banks start to lose faith in the US dollar when the deficit widens and the debt increases (after all, central bankers are supposedly the “smartest guys in the room”, right?) One sign that CBs are currently backing away from the US dollar occurred in the second half of 2016, when CBs saw their foreign FX reserve decrease for the first time in 70 years.
All of this has spooked the Fed into trying to protect the dollar by hiking interest rates more quickly, which raises the question: will the Fed opt for more of what Gromen calls “shooting the hostage?” That is, will the Fed continue raising interest rates to attract foreign investors and domestic fund manager to step in and go long USD to compensate for the lack of USD. But will the Fed take this trade as far as former Fed Governor Volcker did in the 1980s?
To help encourage the private sector to step in for the central banks, Gromen points out that HQLA money market reforms have encouraged asset managers to pour into public debt.
We thought it was really interesting…this recognition that suddenly US deficits being more financed by the US private sector rather than global central banks is beginning to go a bit more mainstream…domestic purchases of US Treasuries by the US domestic private sector has been “encouraged by bank HQLA reforms,” money market fund reforms – and, most recently, tax reform here in the United States.
All of this worked to help encourage the funding of US deficits by the US private sector. Everything was going well until, for the first time since 2009, you saw the US federal deficit begin to increase as a percent of GDP. And (as we’ve highlighted before on your program, so I’ll move through it quickly) this, to us, was a real watershed moment. As you look back, you’d only seen the deficit widen as a percent of GDP seven times in history.
Six of those prior widenings were followed by a US recession within 12 to 14 months. The one time it did not was in the mid-‘80s when the dollar was significantly devalued at the Plaza Accord. So this time last year, and, really, in 4Q16 when we saw this, a lot of people were looking for a stronger dollar. Our case was…that, unless the dollar was significantly devalued, the US economy would likely weaken pretty notably. And that would have some pretty negative implications for the system in general.
Which brings us back to a question that we’ve repeatedly discussed this year: Will the Federal Reserve and other central banks continue hiking rates despite the dangerous squeeze on US consumers, US corporate borrowers and emerging-market debtors that comprise perhaps the three biggest risks to the financial system. So, will the Fed trudge ahead and “shoot the hostage”? Or will it take a step back, realize the dangers that higher interest rates pose to the global system, and consider QE4?