Colin Twiggs, Author at the patient investor

April 16, 2018July 28, 2018

East to West: Headed for war?

Followers of international relations can take their pick of wars at present. There is a trade war brewing between Donald Trump and Xi Jinping, which could descend into a currency war with competing devaluations. We have a Russia waging a cyber war on the West, a Cold War in Eastern Europe and the Baltics, a proxy war in Yemen between Saudia Arabia and Iran, a frozen war in Georgia and Ukraine, and a hot war in Syria that threatens to escalate into a major confrontation between Russia and the West. On top of that we have Kim Jong-un trying to break into the big leagues by test-firing ICBMs over Japan. It’s a tough neighborhood.

The “peace dividend” that was supposed to follow the collapse of Communism is well and truly over. The next major ideological conflict is upon us. Democracy versus the Dictators. For the West to prevail it will have to engage in a coordinated muscular diplomacy over the next few decades. A good start would be Margaret Thatcher’s Statecraft: Strategies for a Changing World (2002):

Margaret Thatcher and Ronald Reagan in the oval office, 1988

“For my part, I favour an approach to statecraft that embraces principles, as long as it is not stifled by them; and I prefer such principles to be accompanied by steel along with good intentions.

…The habit of ubiquitous interventionism, combining pinprick strikes by precision weapons with pious invocations of high principle, would lead us into endless difficulties. Interventions must be limited in number and overwhelming in their impact.

….I should therefore prefer to restrict my guidelines to the following:

Don’t believe that military interventions, no matter how morally justified, can succeed without clear military goals.

Don’t fall into the trap of imagining that the West can remake societies.

Don’t take public opinion for granted — but don’t either underrate the degree to which good people will endure sacrifices for a worthwhile cause.

Don’t allow tyrants and aggressors to get away with it

And when you fight — fight to win.’

But the West also needs to clean up its own house and correct many of the abuses to which Capitalism has been subjected over the last few decades. Martin Wolf sums up the challenges in US-China rivalry will shape the 21st century:

‘The threat is the decadence of the west, very much including the US — the prevalence of rent extraction as a way of economic life, the indifference to the fate of much of its citizenry, the corrupting role of money in politics, the indifference to the truth, and the sacrifice of long-term investment to private and public consumption….’

Bold leadership is required. To fight the wars we have to but, more importantly, to resolve conflicts by other means wherever possible. That doesn’t mean avoiding conflict by retreating from red lines. It means establishing and vigorously enforcing new rules that benefit everyone. No one wins in a war. Whether it is a trade war, a cold war or a hot war. Everyone pays a price.

‘It must be thoroughly understood that war is a necessity, and that the more readily we accept it, the less will be the ardor of our opponents….’

~ Thucydides (circa 400 BC)

Colin Twiggs

Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.

April 16, 2018June 11, 2019

Investing in a Volatile Market

The S&P 500 again respected primary support at 2550. Twiggs Volatility Index is retreating but a trough that forms above 1.0% would warn that market risk remains elevated.

S&P 500

I explained recently to my clients that the odds are at least 2 to 1 that the S&P 500 will recover and go on to make new highs later in the year.

But there is still a significant risk (one-third to one quarter) that tensions will continue to escalate and the S&P 500 breaks primary support to commence a primary down-trend.

If you are risk-averse, as my clients tend to be, it makes sense to adjust your portfolio allocation to cope with either scenario. What I call “having one foot each side of the fence” or “having a bet each way” in racing parlance.

Typical Portfolio Allocation

Gen Stocks are what I call “generational stocks” such as Apple (AAPL), Google (GOOGL), Amazon (AMZN), etc. ASX Income are stocks that yield strong dividends and franking credits.

If you have 50% of your investment portfolio in cash and short-to-medium-term interest-bearing securities (I collectively refer to this as “cash investments”) and 50% in equities, you are well-positioned to take advantage of either scenario.

If the market does fall — the less-likely scenario — you are well-positioned to convert some of your cash investments to take advantage of lower prices when the dust has settled after the crash. If the market rises, as expected, then you have enough exposure to benefit from the continued bull market. In that case, your only downside is the difference in yields between cash and equities.

Bear in mind that:

This only addresses clients’ equity portfolios and does not take account of their other assets;
The allocation is generic and does not take account of your personal circumstances; and
The allocation is addressed at Australian investors.

Although the equity allocation is split equally between Australian and International (mainly US) stocks this does not infer that I rate them as equal market risk. Australian equities includes an allocation to Cyclicals which, in the present situation, could best be described as “counter-cyclical” as this largely consists of gold stocks which tend to rise as the market falls. My “Trump Insurance as I called it in an earlier newsletter.

J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to your sleeping point.”

~ Burton Malkiel

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

April 9, 2018May 29, 2019

Trade Wars: Playing hardball with China

Remember North Korea and the imminent nuclear war? With leaders trading insults on Twitter and bragging: “My nuclear button is bigger than yours.” It may resemble a WWF arena more than international diplomacy but that is how Donald Trump conducts foreign affairs.

The current Twitter war over trade tariffs is no different. Threat and counter-threat of wider and deeper trade tariffs are likely to bounce back-and-forth over the next few weeks. Xi Jinping thinks he has the upper hand because he doesn’t face criticism from a hostile media at home. Nor does he need to front up to a hostile domestic opposition. They’re all safely tucked away in jail. His stock market has already crashed, so there is not too much to worry about on that front either.

Shanghai Composite Index

Xi will do his best to undermine Trump’s shaky support. Targeting Trump’s electoral base with tariffs on soy bean imports (farming states) and steel tubing (Texas) in order to undermine his support. Targeting technology companies like Boeing and Apple, where China is a large slice of their global market, is also likely to elicit strenuous lobbying in Washington. As are well-timed tweets aimed at undermining stock support levels, threatening a major stock market rout.

Dow Jones Industrial Average

Trump probably recognizes that China can withstand more pain, but figures that he has the capacity to inflict more pain. The US has a large trade deficit with China.

And exports comprise a larger percentage of China’s GDP.

In 2010, Paul Krugman wrote:

Some still argue that we must reason gently with China, not confront it. But we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: on Sunday Wen Jiabao, the Chinese prime minister, declared — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.) And Mr. Wen accused other nations of doing what China actually does, seeking to weaken their currencies “just for the purposes of increasing their own exports.”

But if sweet reason won’t work, what’s the alternative? In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action — except that this time the surcharge would have to be much larger, say 25 percent.

I don’t propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world’s economic problems at a time when those problems are already very severe. It’s time to take a stand.

Krugman (no surprise) now seems more opposed to trade tariffs but observes:

….I think it’s worth noting that even if we are headed for a full-scale trade war, conventional estimates of the costs of such a war don’t come anywhere near to 10 percent of GDP, or even 6 percent. In fact, it’s one of the dirty little secrets of international economics that standard estimates of the cost of protectionism, while not trivial, aren’t usually earthshaking either.

I believe that Krugman’s original 2010 argument is still valid and that Trump is right in confronting China. The gap between imports and exports of goods is widening, especially since 2014, not shrinking.

Exports and Imports: Value of Goods for China

But let’s hope that Trump has done his homework. At this stage this is just a Twitter war rather than a trade war, intended to soften up your opponent rather than inflict real damage. But for Trump to succeed he must demonstrate that the US is prepared to endure the pain of a lengthy trade war if needed.

Men naturally despise those who court them, but respect those who do not give way to them.

~ Thucydides (circa 400 BC)

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

March 27, 2018June 11, 2019

Trump’s Trade War

First, let me correct the implication that this is a trade war started by Donald Trump. It is not. His is only the first significant response by the US in a trade war initiated by China more than a decade ago, in the early 2000s.

In 2011 I warned of the danger of a trade war in Five Challenges facing President Obama:

…1. Stop importing capital and exporting jobs.
Japan and China have effectively maintained a trade advantage against the US by investing more than $2.3 trillion in US Treasuries. The inflow of funds on capital account acts to suppress their exchange rate, effectively pegging it against the greenback. Imposition of trade penalties would result in tit-for-tat retaliation that could easily escalate into a trade war….

In Mega-trends and their impact in 2012:

Trade wars
In addition to competition for scarce resources, we are also likely to see increased competition for international trade. Resistance to further currency manipulation — initiated by Japan in the 1980s and perpetuated by China in the last decade — is likely to rise. US Treasury holdings by China and Japan currently sit at more than $2.3 Trillion, the inflows on capital account being used to offset outflows on current account and maintain a competitive trade advantage by suppressing their exchange rate.

In China’s Export Dilemma 2014:

…China has been buying US Treasuries as a form of vendor financing, allowing them to export to the US while preventing the RMB from appreciating to its natural, market-clearing level against the Dollar. The fact that they are attempting to disguise this manipulation, using third parties, means that Congress is unlikely to tolerate further suppression of the RMB against the Dollar and will be forced to take action.

And in 2015, Sectoral Imbalances: Where Have All the Jobs Gone?

A second threat is foreign capital inflows… which commenced in earnest with Japanese purchases of US Treasuries in the 1980s but reached a ‘nuclear’ scale when China joined the party in the early 2000s. While it may appear fairly benign, with foreign investors stepping in to lend Uncle Sam a helping hand, the damage is insidious… these capital inflows were intended to undermine the competitiveness of US manufacturers in both domestic and export markets through currency manipulation.

To understand how currency manipulation works, we need to examine the foreign surplus in more detail. There are two parts to currency flows between nations: the current (income) account and the capital account. The current account comprises the trade surplus or deficit (the net sum of all trade flows between the two nations) and the smaller net income flow from investments.

The capital account reflects all capital flows, whether investment or loans, between the two countries. Again, the sum of the two is always zero. If there is a deficit on the current account (money flowing out), there must be a surplus on the capital account (loans and investments flowing in) to restore the balance. If not, and Japan/China had to increase their exports to the US without a reciprocal flow of capital, the value of the dollar would plummet against the yen/yuan until the trade balance was restored.

Think of it this way. If an importer in the US buys goods from China, they must purchase yuan to pay for the goods. If there are more imports than exports, the demand for yuan will be higher than demand for dollars; so the yuan will rise against the dollar until demand matches supply. But what currency manipulators do is invest money via capital account (mainly in US Treasuries), purchasing dollars to soak up the shortfall so that their currency doesn’t appreciate despite the massive trade surplus with the US.

The impact of this is two-fold. First US manufacturers shed jobs as they lose market share in both domestic and export markets. That cuts into the household surplus as unemployment rises and real wages fall. Second, the US government runs bigger deficits to make up for the demand shortfall in order to buoy economic growth. The end result is that US taxpayers grow poorer — as the size of the public debt millstone increases — while currency manipulators grow richer. The debt binge that led to the GFC was largely fueled by foreign capital inflows. The fact that this imbalance has been allowed to continue is a damning indictment of political leadership in Washington. There is no way that they can be unaware of the damage being caused to US manufacturers, households and to public finances. Change is long overdue.

Why has it taken this long to respond?

The last incumbent in the White House refused to confront the rising menace. A risk-averse culture led to micro-management and Obama’s mantra of “Don’t do stupid sh*t” frequently translated into “Don’t do anything”.

On Obama’s watch the US abdicated its global leadership, leaving the door open for scoundrels like Vladimir Putin and Xi Jinping to step into the void. His legacy is a series of brewing crises that risk a major global confrontation in the next few decades. Taiwan and the South China Sea, India and Pakistan, North Korea, Iran and Saudi Arabia, Yemen, Syria, Ukraine, the Balkans, and the Baltic States. All of these hotspots have the potential to spark a major conflict. It needs just a single miscalculation from an emboldened aggressor accustomed to being able to bully their neighbors into acquiescence.

All this seems eerily familiar. As Winston Churchill long ago warned:

An appeaser is one who feeds a crocodile, hoping it will eat him last.

But back to Donald Trump.

To his credit Trump correctly identified the need to confront the growing threat.

Unfortunately he is not up to the task.

His confrontational style may have worked well when nailing down contractors on construction contracts, or even negotiating media contracts for his show, but is totally unsuited for the role of a leader of the free world.

Trump’s campaign style has left a fiercely divided political landscape, with little support in the mainstream media and even a large swathe of Republicans shocked and embarrassed by his behavior. He has zero chance of uniting the country behind him in confronting these major challenges. His erratic behavior means the Republican party is likely lose control of the House of Representatives at the upcoming mid-term elections, leaving Trump as a lame duck President.

What he does not seem to realise is that belittling treatment of senior officials in his own administration diminishes him in the eyes of subordinates and demoralises his remaining team. It also makes it exceedingly difficult for him to attract new talent.

Internationally, Trump has managed to offend many of America’s traditional allies and is also unlikely to receive much support or understanding from that quarter.

Fortunately the President has been unable to derail the US economy which I suspect will be able to weather the current storm as it has many others. The political mess will continue while the economy keeps on going.

When it comes to stocks, the S&P 500 index is headed for a test of primary support between 2500 and 2550. Breach would signal a primary down-trend but Twiggs Volatility Index is currently in the amber zone, between 1% and 2%, suggesting that the correction is secondary in nature.

S&P 500

From Market Volatility and the S&P 500 in February 2018:

The key is not to wait for Volatility to spike above 2%. By then it is normally too late. An alternative strategy would be to scale back positions when the market remains in an elevated range, between 1% and 2%, over several months. Many traders would argue that this is too early. But the signal does indicate elevated market risk and I am reasonably certain that investors with large positions would prefer to exit too early rather than too late.

My current policy is to maintain 30% cash in our model portfolio (this may not suit investors with different risk profiles) and I am only likely to increase this for US investments if there is a fall below 2500 or Twiggs Volatility remains elevated (above 1%) for at least 3 months. But I am likely to review our cash position for Australian investments in the weeks ahead.

When liberty exceeds intelligence, it begets chaos, which begets dictatorship.

~ Will Durant

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

March 10, 2018

“Headwinds have turned into tailwinds”

“While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds. Fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory.”
~ New Fed Chair Jerome Powell in his first testimony before Congress

Two very important sentences for investors. Expect further rate hikes but at a moderate pace.

Bond yields have climbed in anticipation of higher inflation. Breakout above 3.0 percent would warn of a bond bear market, after the bull market of the last 3 decades, with rising yields.

10-Year Treasury Yields

The five-year breakeven rate (Treasury yield minus the equivalent yield on inflation indexed TIPS) has been climbing since 2016.

Fed Excess Reserves

But core CPI (CPI less Food & Energy) remains subdued.

And average hourly wage rates, reflecting underlying inflationary pressures, continue to grow at a modest 2.5 percent a year.

Private Sector Average Hourly Wage Rate Growth

Real GDP is likely to maintain its similarly modest growth.

Real GDP and Estimates

While the Fed is sitting on a powder keg of more than $2 trillion of commercial bank excess reserves, no one is playing with matches. Yet.

Federal Reserve Bank: Excess Reserves of Depositary Institutions

Those excess reserves on deposit at the Fed have the potential to fuel a massive bubble in stocks or real estate. But investors remain wary after their experience in 2008.

We should be careful to get out of an experience only the wisdom that is in it — and stop there; lest we be like the cat that sits down on a hot stove-lid. She will never sit down on a hot stove-lid again — and that is well; but also she will never sit down on a cold one anymore.

~ Samuel Clemens

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

March 10, 2018

Ben Bernanke: We’re very sorry…. we won’t do it again

….I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

~ Remarks by Governor Ben S. Bernanke
At the Conference to Honor Milton Friedman on his Ninetieth Birthday, University of Chicago, Chicago, Illinois
November 8, 2002

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

March 5, 2018March 5, 2018

Warren Buffett: Bonds and portfolio risk

It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.

~ Warren Buffett, letter to the shareholders of Berkshire Hathaway – February 24, 2018

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

March 3, 2018

The Fed and Alice in Wonderland

In Lewis Carroll’s Alice in Wonderland a young Alice experiences a series of bizarre adventures after falling down a rabbit hole. The new Fed Chairman Jerome Powell will similarly have to lead global financial markets through a series of bizarre, unprecedented experiences.

Down the Rabbit Hole

In 2008, after the collapse of Lehman Bros, financial markets were in complete disarray and in danger of imploding. The Fed, under chairman Ben Bernanke, embarked on an unprecedented (and unproven) rescue attempt — now known as quantitative easing or QE for short — injecting more than $3.5 trillion into the financial system through purchase of long-term Treasuries and mortgage-backed securities (MBS).

Fed Total Assets

The Fed aimed to drive long-term interest rates down in the belief that this would encourage private sector borrowing and investment and revive the economy. Their efforts failed. Private sector borrowing did not revive. Most of the money injected ended up, unused by the private sector, as $2.5 trillion of excess commercial bank reserves on deposit at the Fed.

Fed Excess Reserves

Richard Koo pointed out that the private sector will under normal cirumstances respond to lower interest rates with increased borrowing but during a financial crisis, when their balance sheets have been destroyed and their liabilities exceed their assets, their sole focus is to restore their balance sheet, using surplus cash flow to pay down debt. The only way to prevent a collapse is for the government to step in and plug the gap, borrowing surplus capital and investing this in infrastructure.

One Pill Makes you Larger

Fortunately Bernanke got the message.

US and Euro Area Public Debt to GDP

… and spread the word.

Japan Public Debt to GDP

And One Pill Makes you Small

Unfortunately, other central banks also followed the Fed’s earlier lead, injecting vast sums into the financial system through quantitative easing (QE).

ECB and BOJ Total Assets

Driving long-term yields to levels even Lewis Carroll would have struggled to imagine.

10-Year Treasury Yields

The Pool of Tears

Then in 2014, another twist in the tale. Long-term yields continued to fall in Europe and Japan, while US rates stabilised as Fed eased off on QE. A large differential appeared between US and European/Japanese rates (observable since 2014 on the above chart), causing a flood of money into the US, in pursuit of higher yields.

….. with an unwanted side-effect. The Dollar strengthened. Capital inflows caused the trade-weighted value of the US Dollar to spike upwards beween 2014 and 2016, damaging US export industries and local manufacturers facing competition from foreign imports.

US Trade-Weighted Dollar Index

The Mad Hatter’s Tea Party

A jobless recovery in manufacturing and low wage growth in turn led to the election of Donald Trump in 2016 promising increased protectionism against global competition.

US Manufacturing Jobs

Then in 2017, to the consternation of many, despite rising interest rates the US Dollar began to fall.

US TW Dollar Index in 2017

Learned analysis followed, ascribing the weakening Dollar to rising commodity prices and a recovery in emerging markets. But something doesn’t quite add up.

International bond investors are a pretty smart bunch. When they look at US bond markets, what do they see? The new Fed Chairman has inherited a massive headache.

Donald Trump is determined to stimulate job growth through tax cuts and infrastructure spending. This will certainly create jobs. But when you stimulate an economy that is already at full employment you get inflation.

Who Stole the Tarts?

Jerome Powell is sitting on a powder keg. More than $2 trillion of excess reserves that commercial banks can withdraw without notice. Demand for bank credit is expected to rise as result of the Trump stimulus. Commercial banks, not known for their restraint, can make like Donkey Kong with their excess reserves provided by the Bernanke Fed.

Under Janet Yellen the Fed mapped out a program to withdraw excess reserves from the market by selling down Treasuries and MBS at the rate of $100 billion in 2018 and $200 billion each year thereafter. But at that rate it will take 10 years to remove the excess.

Bond markets are worried about what will happen to inflation in the mean time.

Off With His Head

The new Fed Chair has made all the right noises about being hawkish on inflation. But can he walk the talk? Especially with his $2 trillion headache.

….and the Red Queen, easily recognizable from Lewis Carroll’s tale, tweeting “off with his head” if a hawkish Fed threatens to spoil the party.

One pill makes you larger
And one pill makes you small
And the ones that mother gives you
Don’t do anything at all
Go ask Alice
When she’s ten feet tall

….When the men on the chessboard
Get up and tell you where to go
And you’ve just had some kind of mushroom
And your mind is moving low….

When logic and proportion
Have fallen sloppy dead
And the White Knight is talking backwards
And the Red Queen’s off with her head
Remember what the dormouse said
Feed your head
Feed your head

~ White Rabbit by Grace Slick from Jefferson Airplane (1967)

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

February 26, 2018February 26, 2018

Richard Koo: Surviving in the Intellectually Bankrupt Monetary Policy Environment

Richard C. Koo, Chief Economist, Nomura Research Institute, at the ACATIS Value Konferenz 2016 in Frankfurt

Why QE doesn’t work.

I have the greatest respect for Richard Koo and his unconventional, balance-sheet-recession approach to economics.

It strikes me is that if central banks lower interest rates to stimulate borrowing and borrowing does not rise because borrowers are repaying debt to restore solvency, then it will backfire and hurt GDP. Households reliant on income from investments, especially in financial assets, will experience a significant loss of income from lower interest rates and will reduce their consumption accordingly. Falling consumption will cause a drop in GDP.

Investments in financial assets consist not only of household bank deposits and bonds, but also insurance sector and pension fund investments in financial assets (mainly bonds) which will raise insurance premiums and lower pensions as a result.

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

February 23, 2018

Why is the Dollar falling?

The broad, trade-weighted US Dollar index has been declining since early 2017.

US Dollar Index - Broad and Major Trading Partners

This is the best explanation I have found for current US Dollar weakness. From Bank of Montreal, BMO Nesbitt Burns:

The relationship isn’t perfect, but as a general rule of thumb, the USD declines in years when global growth is above potential. In such years, strong global growth causes commodity prices to rise, which lifts commodity currencies. In addition, strong global growth normally triggers a flood of investment out of developed economies and into emerging economies. As emerging central banks intervene to slow the appreciation of their currencies from these two factors, they sell the USD against EUR and other alternative reserve currencies, thereby causing the USD to decline against both developed and emerging currencies. That dynamic helps explains the USD depreciation in 2017 as well as the 2004-2007 period. The 10Y average of the IMF’s World GDP growth rate is 3.4% and we think that is roughly potential growth. The IMF estimates that global growth will come in at about 3.6% for 2017 and accelerate to 3.7% in 2018.

In addition, the US’s twin deficit fundamental (sum of the current account deficit and fiscal or federal budget deficit as shares of GDP) is another factor that is negative for the USD. Turns in the twin deficit normally precede turns in the USD by 1-2 years and then trends match thereafter. The US’s twin deficit fundamental has been deteriorating for the past two years and is likely to deteriorate further in 2018 and beyond due in part to the tax cuts. When looking at all these factors together with the fact that USD phases tend to last 5-7 years, we feel that we have to forecast a continuation of broad USD weakness—albeit at a slower pace. We project that the broad USD index will fall 1.5% in Q1 and then 1.0% per quarter in each of the remaining three quarters of 2018.

Hat tip to David Llewellyn-Smith at Macrobusiness.

The fall in the Dollar may also be self-reinforcing, as Enda Curran at Bloomberg highlights:

…..On top of the boost already coming from robust global GDP growth, the dollar’s fall over the past year may add over 3 percent to the level of world trade, according to Gabriel Sterne, global head of macro research at Oxford Economics Ltd. Tipping further dollar weakness, the risks are skewed to the upside for Oxford’s baseline forecast for 5 percent growth in world trade in 2018.

“Falls in the value of the dollar oil the wheels of the global financial system, boosting global liquidity by strengthening balance sheets and alleviating currency mismatches,” Sterne wrote in a note. “One important channel is variation in the differential between the cost of raising dollars onshore and offshore. Dollar weakness reduces the cross-currency basis, increases cross-border lending and boosts bank equities.”

The biggest winners will likely be emerging economies given the weaker dollar will lower the value of their dollar-denominated debt, taking pressure off their balance sheets and from credit conditions more generally…..

Finally, from Deutsche Bank (again hat tip to David):

How can it be that US yields are rising sharply, yet the dollar is so weak at the same time? The answer is simple: the dollar is not going down despite higher yields but because of them. Higher yields mean lower bond prices and US bonds are lower because investors don’t want to buy them. This is an entirely different regime to previous years.

Dollar weakness ultimately goes back to two major problems for the greenback this year. First, US asset valuations are extremely stretched. As we argued in our 2018 FX outlook a combined measure of P/E ratios for equities and term premia for bonds is at its highest levels since the 1960s. Simply put, US bond and equity prices cannot continue going up at the same time. This correlation breakdown is structurally bearish for the dollar because it inhibits sustained inflows into US bond and equity markets.

The second dollar problem is that irrespective of asset valuations the US twin deficit (the sum of the current account and fiscal balance) is set to deteriorate dramatically in coming years. Not only does the additional fiscal stimulus recently agreed by Congress push the fair value of bonds even lower via higher issuance and inflation risk premia effects, but the current account that also needs to be financed will widen via import multiplier effects. When an economy is stimulated at full employment the only way to absorb domestic demand is higher imports. Under conservative assumptions the US twin deficit is set to deteriorate by well over 3% of GDP over the next two years.

US Current Account Deficit

In summary:

Rising global growth boosts commodity prices and emerging markets
Central banks in emerging markets then sell Dollars to slow appreciation of their local currency
Fiscal stimulus, such as US tax cuts and infrastructure spending, lifts inflation
Higher inflation causes a bond bear market
Fiscal stimulus also widens the current account deficit
Central bank selling, higher inflation, a bond bear market and wider current account deficits all cause a weaker Dollar

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.