The Trade Week Ahead - All Flows Lead to the US

The risk currencies inside the G10 have found a fair amount of sellers of late as the issues facing Turkey and emerging markets in general hit home.

One thing that is also emerging from the currency flow trades over the past few weeks (in fact the past 24 months) all flows are leading one way – US-bound.

The movement in the USD is justified when you take into account several factors:

• US Employment is booming; non-farm payrolls are averaging over 200,000 jobs a month, underemployment is at the lowest level in 40 years, wage inflation is surging and the unemployment rate is at 1950’s levels. In short – the US has full employment

• US growth is also on the up; the initial Q2 read of 4.1% has t head for the highs of 2014 – then you factor in the proposed government spending (i.e. the ‘southern wall’, road and rail infrastructure etc.) filtering into the economy over the next 2 years GDP will remain high even with the Federal Reserve slowing monetary policy.

• Corporate America; US corporate earnings are at, or above record highs – EPS growth for the past earnings cycle was 29% year-on-year which shows that top-down growth is now filtering through to bottom-up metrics, it is as high as 37% if we strip out the FAANG stocks which drag down overall performance.

The impact these factors are having on US CPI is profound, furthermore, these factors are placing forward pressure on CPI as well. Which, is why we are only 4 weeks from the US Federal Reserve increasing rates for the third time in 2018 and why it is forecasting further 5 rate rises come December 2019 – it is clearly mindful of overheating. However, these factors are also clear drivers of investment and the attraction to the USD, bond yield increases, corporate earnings and overall economic growth. Compare the US to Asia or Europe currently and it makes complete sense.

There is an additional factor that is actually a risk over the medium, it has been a short-term driver and that is US fiscal policy.

Currently the fiscal policy is:

• The highly accommodative tax policies of the past two years could become even more so if the President gets his way.
• Infrastructure spending is forecasted to increase as much as 3-fold over the coming 2 years – which also means a fair amount of sovereign debt.
• Protectionism.

Putting that much additional stimulus into an economy that is also ready humming creates another level of heat.

This exact point was actually highlighted by the RBA governor in his opening statement to the House of Representatives Standing Committee on Economics.

“uncertainty is the possibility of a larger-than-expected pick-up in inflation in the United States. The US economy is experiencing a sizeable fiscal stimulus at a time of limited spare capacity, so growth there could surprise on the upside. At the same time, financial markets remain relaxed about the implications of this for inflation.

I am less relaxed: it is highly unusual to have such stimulatory fiscal policy when the economy is already operating at a very high level of capacity. One can’t rule out the possibility that the Federal Reserve will have to withdraw monetary accommodation more quickly than currently projected, with possibly disruptive consequences in financial markets.”

RBA perspective market shocks are a concern; Australia’s household debt to income ratio is approximately 180% and issues like that seen in money and credit markets this year which have put the strain on lending rates would create a downturn in growth, inflation, and employment.

From a currency perspective, Australia is a net importer of capital yet yield differentials are starting to really blow out. The yield differential between the US 10 year and Australian 10 year its currently at its lowest level since late 1981, and that doesn’t take into account the Federal Reserve increasing US rates a further 150 basis points the record spread was 180 basis point if all things remain equal come June next year a new record will be printed.

Conclusion: capital outflows from the AUD and I think we have been seeing that clearly over the past 4 months – 70 cents is coming and coming fast.

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