Global Macro Commentary

Skeleton Key
Monday, January 05, 2015

Guy Haselmann
(212) 225-6686
Director, Capital Markets Strategy
John Zawada
Director, US Rate Sales

Skeleton Key
The key for global markets in 2015 could likely center on the level of the US dollar (USD) and
the speed of its ascent. The DXY dollar index has risen 13% in the past 6 months to the highest
level since 2005 and appears to be breaking out from a multi-decade channel. It might be in the
early stages of a powerful up-trend, further supported by economic fundamentals and central
bank policy divergences. History has plenty of examples of prodigious consequences resulting
from a strong dollar, particularly for emerging markets.
As the worlds reserve currency, the USD interconnects countries, influences global trade, and
sways markets. The level of the USD materially impacts the decisions of investors, issuers, and
budgeters. Globalization and technological advances have made the global economy more
interconnected than at any point in history. The post-2008 quasi-coordination now appears to
be fracturing into everyone for itself policy; in such, potent capital shifts have emerged.
Dramatic exchange rate movements have taken place during the last six months, which are
spilling over into various markets. Higher levels of volatility should generally be anticipated in
2015. Elevated volatility means less leverage will be required or desired. Large dollar carry
trades will likely be pared, causing a feedback loop that benefits safe assets like the USD and
Treasuries over riskier assets.
The relative strength of the US economy will be USD supportive regardless of whether the Fed
hikes rates or not. A Fed rate hike in the next two quarters would simply increase the speed of
the dollar rally and the speed of the Treasury yield curve flattening. Either way, the Fed will not
be able to do much to stop the USD from appreciating. Nonetheless, it will be interesting to see
what the Fed will do should headline inflation fall to, say, 0%, while core stays near 2%. To
date, FOMC members have called the anticipated drop transitory and a benefit to the consumer.
GDP growth in the US could be as strong today as it is going to get. Global levels of
indebtedness are enormous. Collapsing velocity of money is a symptom of extreme
indebtedness. Fed policies have encouraged cheap issuance to spur growth today, but growing
debt levels borrows from future growth.
However, since US debt levels are trumped by those in Europe, Japan, and many other
countries, the USD looks good on a relative basis. The shale revolution in the US (despite
plunging oil prices) is shrinking the US current account deficit; thus, also acting to support the
USD. On the other hand, a stronger dollar will hurt US competitiveness and exports over time.
Over the past six years of the Feds zero interest rate policy, many countries and foreign
corporations were also able to issue cheap debt in USD. An appreciating dollar increases those
liabilities. Countries like China who have quasi-tied their currency to the USD, become less
competitive with key trading partners (Japan). Furthermore, any country dependent on
commodity exports receives less revenue. Global headwinds are significant.
The bottom line is that a stronger dollar is deflationary. QE provides market liquidity and can
serve to temporarily boost asset prices, but it does little to create jobs or inflation. The biggest
hurdle is too much debt, not the need for more cheap money. QE may also have sizable
unintended consequences through rampant market speculation, herd-like investor behavior, and
the creation of asset bubbles. Those potential ramifications have yet to be realized.
The best investments or trades usually entail envisioning markets going to previously
unforeseen levels and tying it to a coherent story line. Given the simple scenario outlined
above, investors should become open minded to the potential for long-dated Treasuries
continuing to rally. I can envision the10-year note trading to a new low yield (below 1.38%)
and even below 1%. I expect the yield curve to flatten viciously this year. I remain a bond bull
and believe the 30-year yield will trade with a one handle (i.e.; below 2%) in 2015. I could
even be right for different reasons.
How did I get lost, whats the final cost? Could you please help me find the key? Black
Stone Cherry

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