U.S. equity markets have been among the best performing in the world over the past few months while the U.S. dollar has not fared nearly as well. Some articles have cited the dollar’s fall as one of the reasons for the U.S. stock outperformance. A weaker currency can help exporters, and it can boost the earning of companies which sell their products abroad. If the U.S. dollar feels neglected in this relationship, like it’s doing all of the work and getting nothing in return, it can find other currencies to commiserate with. After the Brexit vote in 2016, the British pound’s performance was dreadful, but the FTSE 100 index was very strong. Analysts attributed this to the heavy weightings of multi-national companies in the British index. This year the pound is down again on fears of a hard Brexit, but the FTSE has not risen majestically nor ruled the waves as it did in 2016. 1 1 Close I’ve always liked “Rule, Britannia!”, but only know two lines of the song. Many of the international companies in that index are in the financial, energy and materials sectors which have been battered by the coronavirus slowdown. Even the pound’s best efforts haven’t protected it from sellers.
It’s overly simplistic to look at equities and currencies in isolation – external news can affect each asset in different ways. The recent economic rebound and tightening of credit spreads have rallied equities but hurt the dollar. The benefit of a strong economy to stocks is intuitive, but the dollar’s reaction to economic news has changed over time. In the late 90s the dollar was considered a growth currency, but for the past twelve years, it’s better described as a ghoulish currency. It has thrived in times of economic distress such as when COVID struck in March. The dollar’s self-haven status has become almost mechanical. Banks, levered investors and companies all need dollars when liquidity is tight. Even if these folks would rather own toilet paper than the greenback, they have little choice.
After the crisis ends, the dollar is no longer needed for emergency purposes and it loses the emergency bid and other drivers become more relevant. 2 2 Close People always talk about how they will change the system and end the dollar’s dominance in international settlements, but so far they haven’t had any success. At the beginning of the year, the dollar had an advantage in carry over many other developed-country currencies such as the yen and the euro, but much of it disappeared in March when the Fed cut rates to zero while the ECB and BOJ left rates unchanged. 3 3 Close Both the ECB and the BOJ had negative rates which is why they didn’t cut more. They expanded asset purchases instead. The Fed then added some of the most aggressive asset purchase programs in the world. 4 4 Close Federal Reserve Bank of New York: “Statement Regarding Treasury Securities and Agency Mortgage-Backed Securities Operations,” 3/23/2020. The U.S. went from having relatively tight monetary policy to arguably the loosest in the world, which is both dollar negative and equity positive.
During this time the U.S. trade deficit has widened. 5 5 Close According to data from the U.S. Census Bureau, the trade deficit widened from an average of $48bn per month in 2019 to nearly $64bn in July, the largest monthly deficit since 2008. The relationship between trade deficits and currency returns is complicated. 6 6 Close I’m not going to distinguish between current account and trade deficits here. The current account balance also includes investment income and transfer payments, so is generally a broader, more useful number, but in the past I’ve used it and people have gotten confused. Current account sounds more like something you’d see on a wireless bill than an economic number. In any case, trends in the trade balance are usually the most important driver of trends in the current account. Many countries with trade deficits have strong currencies. If a country experiences very strong capital inflows, its currency will appreciate even if it is running a trade deficit. 7 7 Close To take this one step further, the capital inflows may cause the trade deficit rather than the other way around. When a country gets large foreign investment, it can be offset by folks putting money abroad or the country will have to run a trade deficit. However, a deterioration in the trade balance is often associated with a weaker currency because capital inflows don’t always come to offset it. To put it in quant terms, the trade deficit’s effects on currencies are about change not level.
The U.S. has plenty of characteristics which make it attractive for foreign investment and capital inflows. It has deep, liquid markets. It is perceived to be politically stable and has good legal protections for investors. No other currency has this set of characteristics. The euro is the closest contender, but its markets aren’t as liquid and are fragmented. The single currency has been plagued by concerns about a lack of integration and at times potential dissolution. However, this summer’s coronavirus relief agreement has made the euro a more credible alternative. The agreement included plans for a significant amount of pan-European debt, while easing worries of Eurosceptic disruption. 8 8 Close Bloomberg: “EU Clinches Massive Stimulus Deal to Bind Continent Together,” 7/21/2020. This probably increased demand for euros at the expense of the dollar.
In the past, a big fall in oil prices would probably have helped the dollar. Now, it’s not as clear. The U.S. has become the largest oil producer in the world, and the trade balance in crude and refined products has moved to a small surplus. 9 9 Close U.S. Census Bureau. While oil production is still a small part of the U.S. economy, it is a larger portion of investment. The U.S. dollar is not a petro-currency like the Colombian peso or Norwegian krone, but it no longer gets a boost from lower gas prices. The fall in oil prices is probably a slight negative for equity prices, as oil stocks are represented in some indexes. 10 10 Close Even though Exxon Mobil is out of the DJI.
It seems that political concerns have weighed on the dollar but have not slowed the stock market. Politics seem to play out more directly in currency prices than in outright equity index performance. This is probably because the other factors such as monetary stimulus, economic data and company specific news are bigger drivers of medium-term equity moves. For politics to affect equities, they must have a tangible effect on future company earnings or be so tumultuous as to affect general business prospects. Currencies can move off smaller changes in sentiment and dampen the effect on equities. But remember, as the U.K. may be showing this year, if the political event is big enough, even a large FX move can’t prevent equity weakness. If you look at the calendar, you may notice Brexit isn’t the only potentially market-moving political event this year.
What We Are Watching
U.S. Flow of Funds Data (Monday)
Each quarter, the Federal Reserve publishes data on debt levels and asset holdings across different segments of the U.S. economy. The highest profile component of the report is the Fed’s estimate of aggregate household net worth, which reached a record high at the end of 2019 11 11 Close In both nominal terms and relative to GDP. before experiencing the largest nominal quarterly decline on record in the first quarter of 2020. With recent rebounds in equity and real estate markets, household net worth likely experienced a strong recovery in the second quarter. Developments on the liability side of the balance sheet also deserve attention. If gains in asset holdings were accompanied by declining household debt levels, it could point to continued resilience in consumer spending moving forward.
The U.K. officially left the EU early this year, but the Brexit Withdrawal Agreement provided for a transition period that largely maintained the status quo ante while the two parties negotiated a new trade deal. However, this transition period will end at the end of the year and the two sides have yet to reach agreement, once again raising the prospect of an abrupt and disorderly change in trade rules. The possibility of such an outcome may have risen in recent days after the U.K. introduced a new “Internal Market Bill,” a piece of domestic legislation seen as unilaterally overriding elements of the Withdrawal Agreement related to the status of Northern Ireland and therefore constituting a potential violation of international law. 12 12 Close Financial Times: “UK sets out controversial plans for internal market after Brexit,” 9/9/2020. While EU leaders have stated that a trade deal is still possible, they have indicated that this will only be the case if the U.K. government removes the offending pieces of the Internal Market Bill. As this legislation moves through Parliament, market participants will be watching closely to see whether either side appears willing to give ground in the interest of reaching a deal. If not, rising odds of a “No Deal” outcome could put downward pressure on the British pound.
Eurozone PMIs (Wednesday)
Manufacturing and services sector PMIs in the Eurozone have pointed to modest positive growth in recent months as lockdowns have eased and economic activity has normalized somewhat. However, with a worsening second wave of Covid-19 cases in several European countries, the economic recovery could begin to stall. PMI data for September will be watched closely for any signs that growth is losing momentum. Such a development might weigh on European equities and the euro exchange rate.