Fixed Income

EMD Relative weekly notes: Week Ending August 30, 2019

09/04/2019

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

A Reluctant Fed = A (Dangerously) Stronger Dollar

We think the recent Jackson Hole central banker meeting was something of an inflection point. Given the tariff tit-for-tat that preceded the meeting, the belief (or, more accurately, the hope) was that the Fed would use the potential impact on growth as an excuse to more aggressively ease policy.  

One look at Figure 1 shows that was the knee-jerk reaction, which was then quickly reversed. We believe that the more accurate reading is that the Fed is unwilling to underwrite the trade war, and markets should assume an easing "cycle"—if it is a cycle—will be predicated on growth relative to potential growth—which at 2% for last quarter seems about right—and inflation, which also seems nearly spot on target.

Figure 1

EMD-Relative-Figure-1-9.4.2019.png

Source: Bloomberg. Chart depicts DXY (US Dollar Index). Data as of August 29, 2019

Truly all we know about the impact of trade wars is that they are bad for future and potential growth, but accurately dimensioning their impact as tariffs bob around is impossible. We are sympathetic to the danger that pre-emptive easing just encourages a deepening of the tariff battle on the assumption that lower rates cure all, and we would potentially be left with damaged growth prospects and no fiscal or monetary policy bullets left to respond.

Figure 2

EMD-Relative-Figure-2-9.4.2019.png

Source: Bloomberg. Chart depicts DXY (US Dollar Index). Data as of August 29, 2019

With this backdrop, as both graphs show, the dollar seems poised to continue to rise. This is clearly troublesome for emerging markets as the 3% or so drop in the local currency index this month reflected.  

The dollar index is currently just above 98.5. When Janet Yellen in February 2016 cited the strong dollar and international stresses as a reason to delay a hiking cycle for what turned out to be a year, the index was around 99. It nevertheless rose as high as 103 at the end of that year before falling sharply, to the great benefit of EM assets.

So while we cannot today broadly recommend EM assets as the dollar rises further and the Fed remains reluctant, an accumulation of evidence on trade war damage and a more responsive Fed—which at least dollar levels suggest might not be far away—would make for a very supportive EM environment, if history is any guide.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.