We do not believe the USD has topped, although it may certainly feel like it has judging by the price action over the past few weeks. A dovish Fed, reserve manager diversification away from the USD, and large inflow into the emerging markets have driven the broad trade weighted dollar down by over 3% since its peak in late January. Exhibit 1 provides an indication of the strength of EM inflows; our MS Global Flow Indicator, which tracks 50% of the EM equity market and 25% of the EM debt market on a daily basis, shows that the inflow since the end of February has more than outdone the outflow from emerging markets during the selloff earlier in the year. Since late February, EM has seen over $22bn of net inflows – one of the largest surges in buying historically.
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Within a world of low and often negative DM sovereign yields, it’s not surprising that investors are taking additional risks to generate yield. In the short term, financial yield can diverge from real economic returns. Moreover, in the short term financial returns can lead currency markets, especially when the risk premium in markets is considered excessive. It’s within this environment that we view the current EM rally. Investors are willing to compress EM risk premiums in search for yield. The decline of risk premium boosts EM financial conditions, improving the economic outlook somewhat. Hence, the inflow into EM markets develops growthsupportive second-round effects. But will this second-round growth effect be strong enough to structurally improve the growth outlook in EM? We doubt it.
The tight inverse correlation between commodities and the USD leaves the question of which is the chicken and which is the egg? Does the USD drive commodities or do commodities drive the USD? Neither, we think. The valuation of the USD and commodity prices are both driven by the same fundamental factor, namely Asia breaking away from its debt driven supply policies. Asia’s rebalancing will reduce commodity demand while at the same time causing capital exports into US assets. Though this theme has paused, but it has not been stopped by the recent USD downward correction. Conditions for a USD rally have remained in place and commodity prices should reverse.
When will the USD move higher and commodity prices break lower? Over recent weeks we argued that Asia’s cyclical conditions should remain strong for another three months or so, suggesting that we should watch US economic conditions and it impact on the Fed’s rhetoric. When we say the Fed’s rhetoric, we focus on Yellen, Dudley and Brainard as they continue to reflect the core of the Fed’s thinking. Today, there is another component to add and that is EM financial conditions and their ability to provide required macro-relief to EM countries. Once the effects of financial conditions boosting EM wane, EM central banks and governments will need to do more to actually boost EM growth and improve the outlook.