12/03/2020 – KING DOLLA

KING DOLLAR.

Everyone’s talking about it right now because it’s showing some serious strength.

But why?

Well, it’s all down to the Dollar smile theory *IN MY OPINION* and more specifically, that all important USD liquidity.

Let’s take a look at what the Dollar smile looks like and what its outcomes are – this chart is from Mehul Daya at Nedbank and I have referenced it last year as well in Macrodesiac…

 

It’s a really simple theory.

The dollar strengthens when the US is doing way better than the rest of the world, weakens when the world catches up and strengthens when everyone is doing crap and people are seeking a safe haven.

Specifically, we want to look at what’s happening right now.

Do you remember I mentioned the TedSpread in the note I wrote when I famously used the closing price on XLF to come up with the theory that financials hadn’t moved yet (what an idiot)?

Well, here’s the TedSpread now.
 

When I referenced the TedSpread last month, it had a reading of 0.11.

It’s now at 0.45.

By the way, if you need a lesson on what the TedSpread is, Investopedia tells it best.

Why is this important in the dollar smile theory?

Well, what we’re seeing is the credit risk of banks increasing – and what does that mean?

Banks are wanting to hold USD more to sure themselves up.

Much of the world’s credit infrastructure is based on the dollar, and in periods of stress, people flock to the USD as they understand that it will be the preference to do business in.

As discussed on Sunday evening, the Fed enhanced their swap lines to cope with the need for dollar liquidity – but it seems to have affected little so far.

For example, 3m USD LIBOR (the rate at which banks lend to each other) was 4.5bp HIGHER yesterday – even after the dollar swap line enhancement.

My thinking here is that if we see a real emerging market collapse, we’ll see even more funds that have been invested abroad flow back to the dollar – but this is reliant on the US ALSO being weak.

So the situation here is one that is unfortunately (but fortunately) ripe for USD holders – this virus is indiscriminate, in that all countries can be affected (and seemingly are being affected) which leads to a broad depression of global growth.

So it makes our decision easier to come to in terms of how to play it within the dollar smile framework.

We are naturally already positioned on AUDUSD to the downside, but where else can we look?

I mentioned in the chat that USDJPY is a good shout, but I’ve just seen the extent of retail that are short USDCAD, even with this oil drop.

My thoughts are that we begin to action a USDCAD long rather than the USDJPY short.

The fundamentals of Canada do not look great if we get a real credit blow out.

Why?

Well, debt to income at the end of 2018 for Canadian non-financial firms was 315%!

That is well above historical records…

And this is currently what the options adjusted spread on high yield credit is telling us…

What we must deduce here is whether central bank monetary response and fiscal prudence will lead to an alleviation in credit for firms – i.e will policy allow firms to stay afloat and make good on their bond repayments…

I am unsure that it will, unless there is mass forgiveness of debt…

And with the current oil price, I really think this is CAD negative.

I see little reason why 1.46 isn’t in sight for USDCAD considering the current conditions.

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