curve, weaker USD. We project the USD to fall another 3-4% from current
levels, with the US economy slowing into Q4 working as the catalyst. The
rates market is pricing around a 50% probability of the Fed hiking by
year end, but with growth expected to dip in Q4, headwinds for the Fed
to act are likely to become stronger. We believe weaker US data should
not only reprice US front end rates but also flatten the US curve
further from here, taking the USD lower.
Liquidity hunting yield.
Liquidity conditions remain ample, with Japan’s latest flow of funds
report suggesting its corporate sector cash position increasing to
USD2.2trn. Hence, demand for safe assets remains ample, pushing
valuation for these assets to high if not extreme levels. Exhibit 1
shows that DM yields have fallen in recent weeks, increasing the amount
of negative-yielding bonds to around USD11trn. Investors seem to have
little choice other than piling into yield-enhancing strategies,
suggesting accepting high risks relative to returns. However, it is not
only the hunt for yield that is putting the USD under selling pressure.
Rising USD funding costs coming on the back of rising US LIBOR rates
have reduced international demand for USD-denominated debt. Despite
foreign accounts slowing their purchases of US bonds, US bond yields
have come down, which for us provides additional evidence that the US
economy is slowing down.
The message of falling DM yields.
When bond yields are falling at the same time as foreign purchases
ease, it suggests that the internal supply-demand balance for US capital
market is shifting toward the demand side. This in turn suggests that
the slowing US economy is creating additional net savings, causing its
capital costs to fall. The remaining yield is no longer high enough to
attract the same amount of FX unhedged inflows. Instead, these funds go
elsewhere looking for higher yield, but this yield comes at a higher
USD: Two pressures. So
far, we have argued from a real rate and yield differential point of
view. Exhibit 2 reminds us how real yield differentials have driven
USDJPY lower, which is typical for currencies experiencing near zero
nominal yields and inflation projections falling faster. Exhibit 3
illustrates the US – EM real yield differential working in favour of the
higher-yielding EM currencies. It seems that the current low-yielding
environment promotes two types of currency appreciation. First, where
nominal yields have limited room to fall further, declining inflation
expectations drive real yields higher, pushing related currency higher. Second, high-yielding
currencies appreciate with low volatility, allowing investors to
increasing exposure without violating VAR rules. The USD stands in between these two currency blocks acting as a funding tool.