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By Stewart Richardson on 24/04/16 | Category - FX
The US Dollar has certainly been on the back foot for the last three months, as can be seen in chart 1 below, showing the performance of the Broad Trade Weighted Dollar. However, the picture is a bit more nuanced than a broad index. Against the Euro and Yen, the Dollar was pretty flat for most of last year, with the weakest currencies generally being the commodity linked and emerging market currencies. During the period of recent Dollar weakness, it is the commodity and EM currencies that have rallied most, along with the Yen.
Chart 1 - The Broad Trade Weight US Dollar Index
As we all know the strong Dollar, especially against Emerging Market currencies, actually became a problem for the Global economy and financial markets last year. So it has been seen as a huge relief that the Dollar has been relatively weak in the last three months. Although we are looking to try and position for a strong Dollar in the weeks/months ahead, we would also point out that a strong Dollar, if that is what happens, will have a marked impact on the Global economy and financial markets. Put simply, if we are right about the Dollar, this will be a big thing for all markets.
Our main case for a strengthening Dollar rests on two issues. First, the backtracking on rate rises by the Fed is now widely acknowledged and we think pretty much priced into markets. Second, although we can point to structural problems in most countries, we believe that the US is probably to least challenged in the long term. Or put another way, we think that some of the structural issues in other countries may well be about to become a problem in the near future.
We haven't written about Japan for some time, however, the fiscal and demographic problems there are simply too great for an easy and elegant resolution. Perhaps one of the scariest charts we have seen of late is chart 2 below showing the trends in Government debt per person and the ageing dynamic.
Chart 2 - Japanese debt per person and per cent of population aged over 65
As can be seen, debt per person is approximately US$90,000 equivalent. This is a staggering number. This debt has to be serviced, and with more retired people, there are fewer workers earning an income from which to pay taxes and service the national debt. Despite debt per person being a staggeringly high number already, this will continue to accelerate higher as debt to GDP will keep rising in the years ahead and the population is declining and will do so for decades to come.  
Of course the Bank of Japan and the Government know the above dynamics, and although they have tried all conventional and a few unconventional policies, we do fear that they are not that far away from trying something silly - probably not at their meeting next week, but not far away. With negative interest rates up to and past 10 years on the bond curve, Japanese institutional investors are having to take on increasing risks to hunt down positive yields, and may increasingly invest abroad to do so.
The tipping point will be reached if they do manage to create inflation and investors simply abandon Japan to protect themselves from negative real interest rates. So although the Yen has been incredibly strong, perversely on the back of the move into negative rates by the BoJ, we do not think this makes sense in the big picture. We have a small short Japanese exposure in our portfolio and will be looking to add to it if we see the right market signals.
Chart 3 - The US Dollar versus the Japanese Yen
For the Eurozone, we are worried that the banking problems and lack of a coherent political structure will become a focus again for markets. It appeared to us at last week's ECB meeting that Draghi seemed a little resigned to the potential that they have eased policy pretty much as far as they can, and as he said, we need to give these measure some time to work. He was also at pains again to say that monetary policy alone cannot fix some of the problems of the EZ. Perhaps investors may realise that even Draghi's "whatever it takes" is not enough to overcome structural problems, and again with interest rates so low (negative on a huge amount of debt), we think capital will search out higher yields elsewhere over time.
Chart 4 - The Euro versus the US Dollar
We won't go through all the charts today, but if we are correct that the Dollar is beginning to show signs of life against the Yen and Euro, then this should be enough to derail the recent strong rally in both commodity and Emerging Markets FX. Which brings us back to other markets, and their link with the Dollar.
Now it may not happen overnight, but if the Dollar strengthens, then investors will at some point revert back to thinking about the problems that seemed more immediate late last year and early this year. Also, the short term correlations, as seen in chart 4 below, indicate that the link between the Dollar and Global equities is as strong as ever.

Chart 5 - Global equities and the Broad Trade Weighted Dollar Index
We could easily be wrong about the Dollar in the very short term, and perhaps a continually dovish Fed (let's see what their say at their meeting next week) will lead to a continued weak Dollar. However, Janet Yellen does not seem to be leading a united committee. Their goals have all been broadly met, financial conditions are easier than when they raise rates in December and inflation could be heading smartly higher by the Summer. Despite the market pricing in one rate rise this year at most, we can see a scenario in which the Fed is a bit more active.
So to conclude, after a pretty tough three months for the US Dollar, we think the tide is turning especially when we consider some of the structural problems affecting other countries. We will look to add bullish Dollar positions in our portfolios if market signals confirm that the Dollar is indeed turning higher. A strong Dollar would only increase our concerns about equity and credit markets.

By Stewart Richardson on 17/01/15 | Category - FX
Financial markets were roiled this week as losses currently estimated in the hundreds of millions were realised in the wake of the Swiss National Bank (SNB) abandoning their currency floor with the Euro. The problem for the market in the short term is the worry that higher volatility will force leveraged investors to sell down positions across the board, and that this selling begets more selling and so on. There is a bigger long term concern that we will get to later.
(For those interested or concerned about how RMG fared during this event. Both our FX and Macro strategies made money and are posting positive returns for January.)
With the deflationary concerns having escalated in recent weeks along with the declining oil price and rising market tensions, it is hardly surprising that an event leading to market losses of this scale would cause heightened concerns across all markets. The question remains as to whether these concerns be contained or will they increase in the days/weeks ahead. The answer, as with every similar period in the last few years, depends on the actions of our esteemed central bankers.
A side effect of the SNB move was an immediate assumption that the ECB will "do something big" next week. For months now, Draghi and his trusted lieutenants have been teeing the markets up for QE, and although there has been some obvious opposition to QE, Draghi has been clear that he would deliver if needed. Next week is now his time, and the markets will be sorely disappointed if the under-delivers. 
So will the ECB go big next week likely ensuring a rally in risk assets?  We simply don't know and so we are remaining extremely flexible in our portfolios with close to zero net exposure to either the Euro or Euro Area assets.
Back to the shock SNB move last week. Although we don't know exactly what triggered the timing of this move, we think the reasoning is quite simple. The SNB were having to be significantly more active in defending the 1.20 floor with the Euro, and their balance sheet (reported with a delay) was consequently rising dramatically, having already been at over 80% of GDP in December (see chart below). Simply put, the exploding SNB balance sheet was too high a price to pay, especially as opposition to recent policies had been made very public during the recent referendum.
We believe the SNB strategy of capping the Swiss Franc's value against the Euro was a flawed strategy from the beginning. In effect, the SNB were not only linking their currency to the German orthodox approach that forms the backbone of the Euro's credibility but they were also linking the Swiss Franc to Greece, Portugal and a host of other less orthodox countries that individually have significantly less credibility than Switzerland as a safe haven currency. Indeed, with the obvious pressures building in Europe (with QE likely from the ECB as a result) and Greece yet again at the centre of the political debate, the SNB's currency floor was looking increasingly vulnerable for a number of weeks.
This brings us onto the first of two major issues that we believe are becoming the most significant factors for investors to consider. First, the SNB has lost credibility. They have lost tens of billions of Swiss Francs on their FX policies since 2009 which must be the largest single loss in the history of foreign exchange markets. Secondly, their policy encouraged some market participants to believe they could short or borrow Swiss Francs (reinvesting into higher yielding assets - a form of carry trade) with the certainty that they couldn't lose on that leg of the trade or so they believed. So now we know that traders/investors can lose large sums of money blindly believing that central banks have their backs!!
If traders can lose money blindly taking risks assuming the SNB would not allow them to lose money, then we have to entertain the thought that the same could happen to those assuming the Fed and the ECB have their backs via QE and zero rates. Could it possibly be that leveraged players who are short the Yen and long Japanese stocks assuming Japanese QE will actually lose money?
At RMG, we are huge believers in a free market setting the right price for goods/services/assets. When central banks intervene, it should be in extreme circumstances only and not constantly trying to force prices higher for assets and weaken exchange rates (we are not even sure how successful these policies have been for the real economy, and we are certain that we haven't seen the true cost of undertaking these policies. That will have to be considered another day otherwise we would never finish writing this piece).We also believe that history will look back unkindly on all of these policies.
If investors begin to believe that the Fed PUT is much further below the market than they would like, and liquidation pressures rise quickly, who are they going to sell to? Regulators including central banks have built a market structure that is simply not robust enough to absorb intense selling. Liquidity is at a huge premium in markets nowadays, as seen this week in FX, last October in the US Government bond market, and daily in the Junk and EM bond markets. Banks simply do not make markets in size anymore and High Frequency Traders step away from disorderly markets. When there is no one to take the other side of the trade, an avalanche of selling causes huge "air pockets" as seen in Swiss Franc trading this week. And who wants to be exposed to that sort of risk?
So the Swiss move this early in the year makes for an incredibly interesting and probably volatile 2015. We believe that nearly all markets are overvalued due to years of central bank largesse and if markets begin to question their credibility, then we will see many more air pockets such as were seen this week. Of course, the ECB, BoJ, FED and PBoC can appease investors and soothe their concerns by changing a bit of language here and adding some liquidity there but their policies are having a decreasing impact on markets and are simply adding to the size and scale of potential unintended consequences.
For our part, we remain cautious on equities and believe that further market stresses this year will ensure that no major central bank will raise rates for a very long time to come. The one asset that should benefit in a period of declining central bank credibility is Gold, which is up more than 3% since just after the SNB decision.

By Stewart Richardson on 13/09/14 | Category - FX

Financial markets are beginning to show signs of change. Volatility in FX markets in particular has increased (see first chart below) which is often the canary in the coal mine for other assets. Having witnessed a few false dawns already this year, we believe that the signals being generated this week are the real deal. The FOMC meets this week and is likely to discuss the timing and trajectory of rate rises which could appear more hawkish than many investors expect.

Volatility in FX markets, along with other assets, was in a very steady decline all year and reached historically low levels in the Summer. The chart below shows 3 month 'At the Money' volatility for G7 currencies. Having touched 5% in the Summer, there has been a large increase in the last two weeks up towards 8%. The current level is still low by historical standards and we expect volatility to move higher in the months ahead driven by diverging central bank actions, reduced US Dollar liquidity and the seemingly inexorable drive towards currency wars as politicians resort to the simplest, yet inevitably most harmful, action instead of implementing tougher structural reforms.

The USD bullish case really began to develop in May when the Euro started to weaken on Draghi's commitment to significantly ease policy. The recent weakness in Sterling (obviously driven partly by concerns over the Scottish independence vote) helped strengthen the case. However, it was still unclear as to whether this was USD strength or Euro and Sterling weakness. The broad based performance in the US Dollar this week significantly strengthens the general USD bullish thesis. In particular, strength against commodity and EM currencies makes us believe that a significant rise in the Dollar is only just starting.

The chart below shows the weekly Aussie Dollar versus US Dollar. Last week, the Aussie Dollar fell by 3.6% from an historically significant pivot point and was the worst performing major currency by a long way. Having been a popular carry trade or high yielding currency to own, this breakdown is a sign that investors are shifting away from 'risk on' trades. It is also significant that the decline happened in a week when the employment data showed that Australia created the most jobs in August in over 20 years. When popular carry trades blow up like this when volatility is rising from historically low levels, it could mark a sign of broad 'risk off' not just in FX but probably also in equity and credit markets.

Looking ahead to the Fed next week, the hawks (including us) are looking for a change in language indicating that the rate rising cycle will start sooner and be more aggressive than current market expectations. This would be very supportive for the US Dollar and should weigh on bond and equity prices. We believe that a number of the regional Governors are on the hawkish side of the camp (see below) and the question remains on whether Janet Yellen holds the upper hand, remains dovish and talks about rates remaining low for an extended period of time after QE ends next month.
There were two interesting papers this week that support the more hawkish scenario. First, the San Francisco Fed published a paper on Monday concluding that investors are expecting a more accommodative policy than FOMC participants. This is quite a statement to make, although we simply don't know whether these are the personal views of the authors and simply stating facts about the rates market versus the Fed "dots". Alternatively, is this the Fed subtly trying to communicate with the market that they are serious about rate rises starting Q2 next year and that the market is wrong in being so dovish?
Secondly, economists at the Federal Reserve and the Cleveland Fed presented a paper on Friday discussing the drop in the US labour participation. The authors blame the lower participation rate on "ongoing structural influences that are pushing down the participation rate rather than a pronounced cyclical weakness related to potential jobseekers' discouragement about the weak state of the labor market... We see further declines in the aggregate labor force participation rate as the most likely outcome." This is not a view shared by Janet Yellen who believes that the decline is due to discouraged workers dropping out of the workforce who could subsequently return when the jobs market improves. This is basically the structural versus cyclical argument and if the balance tilts towards structural, implying there is little that the Fed can do to improve the situation, then Fed policy likely shifts hawkishly.
Assuming a more hawkish Fed next week, we look for US Dollar gains to be extended immediately. A less hawkish Fed probably just delays rather than derails the higher rates environment and so will only delay the next move higher in the US Dollar. Regardless of the ebb and flow in the Dollar, we should expect the Euro to be independently weak in the months ahead.
Moving onto other asset classes, what happens to equities and bonds if the Fed does move more hawkishly?
At the moment, the interest rate market is too dovish compared to the Fed dots, and so a confirmation of the dots or something more hawkish could have quite a marked impact on the short end of the curve. We continue to be of the view that developed economies will struggle in the face of "secular stagnation" headwinds, and we see the long end of the curve anchored at low yields with any rate rise cycle increasing the potential for a recession in 2015. So we are looking for a flatter interest rate curve in the US.
In equities, the August rally has so far stalled in September despite the recent policy initiative from the ECB. We continue to believe that the upside for equities is modest with Fed QE nearly at an end and rate rises being discussed, and in fact, equities look vulnerable to a decent correction. That said, our fundamental analysis has not helped us in recent months, and with the short term trend still upwards, we need to see downside momentum to develop. Perhaps this will coincide with a more hawkish Fed.
We continue to see divergences build. For example, the S&P versus junk bond spreads, shown in the chart below. Volume remains tepid and the divergences between price and advance/decline and price versus new 52 week highs/lows is now quite striking. Perhaps the chart to really keep in mind is the S&P 500 versus Junk bond spreads. We believe that both assets are in bubble territory, but history shows that equities are more vulnerable after junk bond spreads have widened out - exactly what is happening now. It is no accident that this is occurring as QE is coming to an end. If the under-performance of Junk bonds continues and equity market volatility increases, then equity markets will become increasingly vulnerable to a 10% + correction which could easily morph into something more serious.
To wrap up, financial markets are changing character. This change is starting before a very important Fed meeting this week (not to mention the Scotland vote and ECB liquidity announcements) and although this uncertainty may well be yet another false signal for the bears, can the bulls continue to ignore ALL the bearish signals? At the end of the day, it will be lower prices coupled with a more hawkish Fed that will cause investors to become increasingly bearish. Although we can only speculate when that time will be, we would caution that with poor liquidity in markets and a large number of investors potentially looking to exit at the first sign of a change in long term momentum, it may not be easy to sell at the price you want.  

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RMG Wealth Management LLP is authorised and regulated by the Financial Conduct Authority (FCA). These reports are for general information purposes only and do not take into account the specific financial objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed.