The dollar remains the cleanest shirt

The dollar remains the cleanest shirt

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An update on the US economy for the second quarter is just an appetiser for markets before the main dish is served up by the Federal Reserve meeting at the end of July.

Growth in the US economy eased back from its first-quarter pace, but courtesy of robust consumer spending, it came in at a 2.1 per cent annualised rate for Q2. That beat a forecast 1.8 per cent pace and came after the economy expanded at 3.1 per cent in the first quarter. 

But scratch beneath the surface and the effects of the ongoing trade war could be spotted. Growth in business fixed-investment dropped 0.6 per cent, marking the first decline since the first quarter of 2016, while inventories and net exports sliced 1.5 per cent from growth, partially offsetting a 4.3 per cent rise in personal consumption. Core price pressures rose 1.8 per cent, but that still arrived below an expected 2 per cent pace.

All told, the Fed remains in play for easing next week, highlighted by a minimal change in short-dated Treasuries. Wall Street hit fresh intraday records on Friday as investors cheered earnings results from Alphabet and Twitter. 

Adam Cole at RBC Capital Markets says the GDP data support his view that Jay Powell will next week “characterise the [rate] cut as a quick dab on the accelerator as an insurance policy against global risks, not the start of a normal easing cycle”.

Looking at the US government bond market may not provide a particularly insightful view of Fed policy beyond July as nearly $14tn of global negative-yielding debt is a powerful anchor capping Treasury yields. Some investors even argue that there is a chance US yields could head towards zero in the coming years, as this FT Insight column explains.

Perhaps the more interesting story at the moment is the direction of travel for the reserve currency. On Friday the dollar index climbed to its best level since late May versus a basket of leading rivals. A casualty was the UK’s pound, which slid below $1.24, its lowest level since April 2017.

The dollar also received a boost on Friday after Larry Kudlow, a White House economic adviser, said the administration had “ruled out” currency intervention.

That led the dollar index on track to set a triple top, above the 98 level and approach the twin peaks of April and May. In a global easing cycle, the dollar is undoubtedly the cleanest shirt in the G10 laundry hamper, while a desire for emerging market currencies is for now being driven by a hunt for yield and carry. 

The dollar can clearly handle a 25 basis point rate cut from the Fed, but if there’s a renewed burst of strength towards the late-2016 peak of 103 in the dollar index, that would trigger some anxiety and start testing the current strong appetite for risk seen most notably for EMs. It would also change the White House’s tune. 

Next week’s Fed meeting may well throw a little cold water on further easing after July, and that’s the kind of policy guidance that will spur a firmer dollar. From there, any tremors in risk assets would trigger a sharper rally in the dollar.

Quick Hits — What’s on the markets radar

More money chasing bonds — It seems investors do not buy the idea of central bank easing boosting economic growth to a level that sparks inflationary pressure. Here’s Bank of America Merrill Lynch on the latest weekly figures ending July 24: 

“Inflows to fixed income accelerated to $6.03bn from $4.97bn in the prior week on the back of stronger flows for high yield, loans and government bonds, while inflows to high-grade bonds remained stable. Equities reported a $6.43bn outflow following a $4.37bn inflow in the prior week.”

Russia cuts again with more to come — As expected, the Russian central bank eased for a second time this year, cutting its overnight rate to 7.25 per cent from 7.5 per cent. The rouble remains 10 per cent higher for the year, near its strongest level since January. Carry trades in EMs remain popular for investors seeking high yielders.

Value only gets cheaper — DWS highlight how the valuation premium for growth versus value stocks (MSCI ACWI Growth and Value index) has reached record levels and offers this stunning observation: “Measured by the price/earnings ratio (P/E ratio), growth costs 70% more than value.”

Economic growth running below trend and lower bond yields that boost the value of future cash flows for faster expanding companies help explain the preference for “growth stocks”.

As Thomas Schuessler at DWS observes: “Expensive stocks are becoming ever more expensive while the cheap even cheaper”, and while he expects some moderation in this trend, adds: “We believe quality growth stocks will continue to find buyers in an environment that combines low interest rates and high growth.”

The epic divergence between value and growth is a major talking point for investors and there are hopes that central bank easing will eventually boosts economic activity and trigger a value comeback, a point made by UBS earlier this week. 

Here’s Société Générale expressing a similar sentiment: “As a classic cyclical strategy, value also stands to gain from the eventual economic recovery from the monetary easing policies.”

Rotations are a crucial driver of markets and while value will attract contrarians, unless easing delivers a boost in the coming months, any bounce will fade. 

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