[USD] FX Alert: Decoupling is alive and will kill the USD

FX Alert: Decoupling is alive and will kill the USD

Introduction
We have stated for sometime that our FX Strategy was based on view that the market will not believe signs that the US economic recovery loosing steam (fiscal stimulus running out and the overhang of unsold properties dampening the recovery) will drag the rest of the world down with it. This theory was discredited last year after the synchronised global downturn of 2008. However that downturn was caused by a global banking crisis. It is almost impossible for any economy to withstand a global shock unless it is a completely closed economy. Originally decoupling described the belief that global growth depended on US consumption growth -hence the phrase 'when the US sneezes the rest of the world catches a cold'. The latest evidence suggests that the global economy is indeed decoupling from US economic growth prospects.

Evidence of Global Decoupling
Global data over the last 24 hours has provided evidence of this. The fact that Chinese GDP growth has accounted for roughly a third of global growth this year tells its own story. Moreover as the latest GDP figures show its recovery is not getting out of control and it is being coupled with subdued inflation and strong retail sales data (as well as FDI). As such the Chinese authorities have room to stimulate the economy to keep it growing at near double-digit rates if external demand slows. Given they managed to do this in 2008, to repeat it in 2010 H2 would be far easier. Simple arithmetic also suggests that China's contribution to global growth can only increase from now. So decoupling is likely to gather steam not dissipate in the coming quarters. Somewhat perversely a weak US economy will help this process, as it will keep commodity price lower than otherwise and hence inflationary pressures on the back burner.

Moreover data in other Asian economies have also supported our view that fears of a China slowdown or an Asian led slowdown are overblown. South Korea's trade data for June released today showed very strong growth in exports. Yesterday we saw an even more important piece of evidence in favour of Asia decoupling. SGD GDP data showed a very robust rate of growth in Q2. But the breakdown showed that growth was increasingly being driven by intra-Asian activity (i.e. not dependent on the weakening deleveraging Western economic growth). Tourism is one of the key drivers of Singaporean economic growth and its tourism sector is booming as Asian tourists are more than making up for their more budgetary constrained Western neighbours. There has also been jobs growth elsewhere from Canada, Australia to Brazil. Even the latest UK data showed a healthy pace of employment growth (although that is less likely to last given the new fiscal austerity package). This is important as jobs growth can lead to a self-sustaining engine of domestic demand.

Fears over a China slowdown
But this is fairly reliant on Chinese growth, around which two fears exist. First that its economy is built on an asset bubble that is about to burst and drag the economy down with it. Second that inflation in that economy will get out of control and force a hard landing. The first fear increasingly appears unfounded. This is because interest rates or credit tightening can be much better targeted in China since the authorities control the banks (e.g. preventing third home loans etc). Moreover the Chinese have far higher savings so their property boom has not had to rely anywhere nearly as much on leverage. So interest rates in China is not the blunt instrument that it is in Western economies. All indications are that they have done this successfully.

The second fear on inflation also increasingly appears unfounded. NDRC (China's top economic policy making body) came out today to say inflation is not set to pick up quickly. If you look behind the headline CPI figures then it shows most of the price pressures is due to imported/commodity goods not domestic price pressures. Hence this suggests that by allowing CNY appreciation it could also be used to control inflation as well as sustaining domestic consumption growth. So both of these China fears appear less worrisome on closer examination and recent developments.

Best evidence in favour of Decoupling
The recent earnings seasons has probably provided the best evidence for decoupling. Over the last week we have seen good earnings news from Alcoa (mining), Google (on advertising), Intel (tech/industrial) and JPMorgan (financials). More often than not the common theme underlying their performance has been Chinese or Asian demand. Around 65% of Intel's sales were made in Asia. These companies also tend to give forecasts for their business for the next quarter. So far their forecasts don't suggest any weakening in the global engine of growth (i.e. Asian demand).

Implications of Decoupling for the USD
A lot of the recent moves in FX markets suggest that the market is indeed starting to price in a decoupling scenario in. It helps explain why negative US economic data has been negative for the USD rather than boosting risk aversion and hence safe haven demand for the USD (as happened earlier in the year). Over recent weeks we have seen both the AUD and JPY rally simultaneously against the USD. Given that we have for most of this year gone form the risk on (JPY strength) trade to the risk off trade (AUD strength), it is very rare to see them both rally against the USD at the same time. But such patterns of behaviour are consistent with global growth decoupling from the US. Falls in USDJPY still reflects weak US growth prospects as it is a large trading partner. But the resilience of the AUD is evidence that weak US growth prospects is not generating broader risk aversion and safe haven demand for USD. Weak USD data was a significant driver of the rise in EURUSD from 1.19 to 1.29 as even EUR bears have started to comment on how it was making USD assets unattractive. It is no coincidence that on the day we saw a good long-term Spanish auction (i.e. Thursday) we also saw USD 2year Treasury yields hit a record low of 0.58%. Hence a declining demand for USD is not being associated with less demand for US government securities. So the USD is still a safe haven currency in this sense but weak US economic growth no longer generates broader risk aversion and safe haven USD demand. Also it suggests that this is not a view about the fiscal credibility of the US pushing the USD down. So we can see from market price action decoupling is getting priced even if not yet from the economic data.

Finally as decoupling gets priced in then this could once again lead to a negative correlation between the USD and equity markets. This is because equities will rise on good earnings (driven by Asia), which in turn will cement the decoupling view. This should also mean that the USD will be increasingly used as funding currency and so depreciate as people use it to fund higher yielding opportunities.
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