Key Takeaways
- One year after the WHO declared COVID-19 a pandemic on March 11th, 2020, markets have shifted their focus beyond the pandemic. Roaring 20's levels of optimism are fueling inflation expectations and pushing bond yields higher. Climbing interest rates have hurt growth company valuations and strengthened the dollar as markets adjust for higher prices ahead.
- The greenback has shined this year, up 2.5%, amid recent market volatility, surprising doubters of its role as a safe haven after last year’s sell-off.
- The British pound has rebounded from multi-decade lows. With the UK leading the developed world in vaccinations per capita, the sterling is poised to see its pre-Brexit self.
What happened
Long term interest rates soared. Expectations of a stronger economic recovery, large fiscal stimulus and inflation have pushed long-term interest rates higher, with the 10-year US Treasury yield rising over 60bps this year, surpassing 1.6%. The dollar has benefited from the higher yields, rallying to 3-month highs in the face of a market that’s short USD. The market re-pricing higher discount rates has hurt growth company valuations, continuing a rotation among investors into value companies. Emerging market currencies have quickly sold off as higher US yields have made investors rethink the historic low yields across the emerging world.
COVID vaccinations ramped up. Four major effective vaccines were approved for emergency use. In the race to vaccinate the world, the UK is leading with more than 36% of its population vaccinated with at least one shot; the US follows with just over 18%, and the EU lags at 6%—this, while new Covid cases remain stubbornly high across the EU.1 Interestingly enough, these three currencies have performed in similar order to their vaccinated population so far in 2021: Pound Index +3.2%, USD Index +2.5%, Euro Index -2.0%.2
Dollar held strong as a safe haven. Amid market volatility with bonds selling off globally in February, the Japanese yen and Swiss franc failed to live up to their status as safe havens. Rising commodity prices didn’t help these two historically known safe havens, as both are heavy importers of natural resources. In February, among G10 currencies, the JPY and CHF sold off the most against the dollar, falling 4% so far this year. Meanwhile, the Bloomberg dollar index is up, almost 2.5% YTD 2021. Even as the dollar has broadly lost near 10% since its high last March, it is still playing its role as a safe haven in times of uncertainty and market volatility.
What’s in play
FOMC eyes long term treasury yields. Surging long-term treasury yields have caught the attention of the Federal Open Market Committee (FOMC) and its Chairman Jay Powell. Powell has avoided expressing concern that high interest rates will slow the economy. In fact, he has welcomed the steeper yield curve as a signal that markets are optimistic of a recovery. Yet the sharp sell-off in the world’s largest bond market could have deeper economic consequences, should it cause financial conditions to tighten. In the event Powell and the FOMC indicate there could be additional policy considerations to address the yield surge, look for volatility to be quelled, propelling a rush to risk assets and another dollar sell-off.
Record stimulus package approaching fast. As of this writing, the Biden Administration is close to passing the $1.9 trillion “American Rescue Plan.” The market has priced in this gargantuan fiscal stimulus which has partly driven yields higher. The influx of cash should add to an already high US savings rate to help the economy reach capacity once the pandemic fades away. Throwing more cash at the economy with few strings attached will cause the Federal deficit to balloon this year. Expect an equally giant infrastructure bill to come later this year or next. Larger budget deficits for the next few years will pressure the Fed to indefinitely buy treasuries as long-term yields tick higher, pushing the USD further along its sell-off from the past year.
The pound regains its mojo. Just 12 months ago, the pound was hitting 35-year lows, the pandemic was raging through London and great uncertainty surrounded the likelihood of a Brexit trade deal by year-end. Now the pound is charging ahead towards pre-Brexit levels, the UK leads the world in Covid vaccinations, and a trade deal has been reached. The sterling has been resilient throughout 2021 and market volatility, rallying 1.5% against the dollar and over 4% against the euro after leaving the single market.
What’s next
Commodity currencies to outperform. This year, currencies of commodity producing nations (AUD, NOK, CAD) have outperformed as everything from crude oil to copper to corn prices have risen by double digits. Rising commodity prices reflect higher inflation expectations ahead that bring tailwinds to currencies of major commodity producers and exacerbate headwinds to commodity importers. Look for the NOK, CAD and AUD to benefit from higher commodity prices while EUR, JPY and CHF underperform in a world of higher commodity prices.
Tantrum Round 2: Emerging markets currencies have been walloped as US Treasury yields have climbed. Even though the Fed has maintained it has no plans to unwind its QE program or think about raising rates3, this spike in yields and EM currency reaction is reminiscent of the market tantrum after the Fed mentioned tapering its QE program in 2013. After the tantrum in 2013 and resulting market re-positioning, we saw several months of relative stability in EM currencies. After this most recent bout of EM sell-offs, look for FX rates to stabilize, providing for a carry trade opportunity on high yielding EM currencies. As treasury yields stabilize, look for EM currencies like INR, MXN and PHP to settle down as well, setting up for a nice carry trade over the following 6-12 months for sellers of USD.
Yuan faces a post-Covid world of new trading ranges: In a post-Covid world, the Chinese will continue to exert their financial influence using the renminbi as a main tool in their strategy. If more widespread RMB adoption is the goal, intentional devaluations and market manipulation will be more frowned upon in today’s global community than their last devaluation of 2015. We now have a clear technical ceiling from the recent highs of 7.1965 during the trade war and Covid. Should we pass the 7 handle again, we have a firm level to look up to for resistance. The RMB has steadily rallied against the dollar since those highs of May 2020, recently finding support of 6.4 and providing a new trading range that looks more like a pre-Trump trading range of 6- 6.75 than above the psychological level of 7.
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