By John Hardy

A great reset of the global debt bubble is upon us. The first steps washed over the currency market with the usual patterns of risk-off behavior and squaring of crowded speculative positions. EM currencies have collapsed, the smaller G10 currencies are universally under pressure.

Interestingly, the US dollar came under initial pressure against the Japanese yen and euro on the initial deleveraging, but later mounted a broader and more vicious rise akin to what we saw in the worst phase of the 2008-09 crash. This US dollar rise came even as the Fed, just as then, chopped rates to zero and launched all manner of QE and liquidity facilities.

And it is very likely, just as back in early 2009, that we can’t call a bottom for the markets or peak moment for the crisis until the dollar itself has turned. It was in March 2009 that both the S&P 500 bottomed and the US dollar peaked. With so much of the world’s debt and other instruments denominated in US dollars, the Fed struggled to get ahead of the contagion as everyone deleveraged in a mad ‘dash for cash’.

The situation echoes back as far as 1933, when the beginning of the end of the worst phase of the Great Depression came after FDR finally devalued the USD against gold (about three years later than should have been the case).

Chart: The US dollar in 2008-09 and now

We have entered this yet-to-be-officially-named crisis in a very different place than where we entered the GFC. At that time, the USD was already quite weak as the Fed’s prior easy money policies of the 2002-04 era supercharged USD liquidity and investment bank balance sheets, with JPY and CHF carry trades adding to global liquidity.

This time around, we entered the crisis run higher in search of carry before the COVID-19 outbreak. The big spike higher in the dollar goes to show that when crisis comes calling the world can’t get its hands on enough US dollars. We likely need the US dollar lower to call an end to the equity and risk bear market. (Chart source: Bloomberg)

The trigger of this credit crunch of unforeseen magnitude is of course the coronavirus outbreak. But the severity of the fallout is a product of a financialized global system made so incredibly fragile by the leverage encouraged by ZIRP and NIRP, plus the QE medicine used to alleviate the ills of the last crisis.

From here, it may take at least a couple more quarters to establish a cycle low in the market and a high in the US dollar — even as authorities swing more determinedly into action than we have ever seen. This time around, due to the severity of the issue policymakers have no qualms about throwing orthodoxy out the window and printing infinite amounts of cash to drop on the economy.

Contrast that with the halting efforts in the US that kept the system from clearing fully from 1929 until the outbreak of WWII in late 1941 with Pearl Harbor. The cycles have been getting shorter since the Great Depression, with market top to market bottom in the GFC coming in around 18 months.

Relative to the global financial crisis, the medicine this time around will include far more helicopter money and far less QE. Real GDP may be slow to recover — but helicopter money is going to help nominal GDP come roaring back at some point first.

A note of encouragement in a scary environment: long-time investors know that crisis points are also the points of maximum opportunity for those with cash in reserve. And the coming six to 12 months will bring extreme value to various oversold assets, regions and their currencies, even if calling the timing of the low is a fool’s errand.

Below we look at new themes for currencies that we think are likely to emerge as we transition through and to the other side of what may prove a U-shaped recovery with a bumpy bottom into 2021. These FX themes and drivers differ from those of the recent and pre-GFC past, when carry and investment flows in a globalized financial system were the chief focus.

Putting out deflationary fires = inflation?

We are convinced that the policy medicine of MMT will eventually be employed on sufficient scale to avoid deflationary outcomes. If so, and if inflation stages a sharp recovery and even begins to run hot, the key metric that many are likely to focus on for relative currency strength is the real interest rate — how much the CPI exceeds the policy rate at various points on the sovereign bond curve. Those countries overheating the printing press and running ugly, negative real rates will eventually find their currencies weakening rather than benefitting from the initial push of fiscal stimulus.

This is actually the normal pattern for EM currencies. Watch the coming months very closely for this inflation transition to arise, as the demand crunch risks destroying capital and thus the available supply of key products once the economy finds its feet again. Plus, as the dust settles in coming quarters, investors should track the purchasing power measures of various currencies as we inevitably discover that some are proverbial babies that have been tossed out with the bath water, as is always the case in a crisis. These could include SEK, CAD and (with some patience) sterling and Aussie.

Autarky and a new deglobalization

The coronavirus outbreak and the US-China trade policy hostilities that preceded it are likely to add to the deglobalization impulse that was already under way before the virus outbreak. Countries and economic blocs like the EU will have a vastly increased interest in ensuring that key security and health products — think medicines, surgical masks and ventilators; some basic goods; national defense products and electricals — are made closer to home. This will drive investment and current account considerations that will prove critical for currency fundamentals, with perhaps fewer traditional financialized capital flows.

Those countries that are vulnerable from a current account perspective could be punished (the UK needs to show it can balance its current account if this era of financialization is waning, for example). On the flipside, the traditional major export powers like Germany (EUR or dare we ask DEM eventually?), Singapore (SGD), Sweden (SEK), Switzerland (CHF) and others may find this a less friendly environment for their currencies as their access to international markets is reduced — all relative to purchasing power as noted above.

Commodity exposures

With the era of over-financialization likely ending, hard assets and commodities that are difficult to produce or replace domestically could experience a renaissance and drive significant gains for individual currencies. The AUD, NZD and CAD are likely eventual winners in this category (once they get to the other side of their domestic credit bubble unwinds). So could the BRL and even the RUB, from extremely cheap levels.

The USD is also a winner here, but needs a significant markdown in the years ahead to allow a global recovery to proceed. And it could be in trouble from a real interest rate perspective, as discussed above. The JPY is vulnerable if commodity imports rise and deglobalisation risks its export markets, alongside long-standing issues like its shrinking labour force and enormous retired population.

Ending the USD dependency

In addition to the drivers above, likely the most interesting theme afoot in coming years will be the scramble to find alternatives to the US dollar. This crisis is proving even more clearly than the last one that the fiat-USD-as-global-reserve-currency system is dysfunctional beyond all attempts to salvage it. Complicating the search for an alternative is the fact that in a deglobalizing world, Bretton Woods-style arrangements will prove very hard to come by.

— The writer is head of FX strategy at Saxo Bank