De-Dollarization and the Rise of EM Exceptionalism

I want to make a brief comment on what China and the Trump tariffs means for markets. The first is economically, it means uncertainty and that transmits into recession risk. Just uncertainty, right? The reduced propensity to consume or invest. And that increased recession risk is bullish for interest rates.

It's a somewhat global phenomenon, so it's bullish for global rates, arguably. That's number one. And note, bullish rates is good for bonds. It can be bad for currencies, but second, FX deals look like they're happening. Now, a lot of sell-side economists, I used to be one, are going to wait for the memo on the deal that was done. And that often never happens or happens years later. We've had Plaza Accords, but the tea leaves all indicate that FX is part of these tariff negotiations. An extreme example. If China, imagine the repercussions if China devalued its currency after a trade agreement with the United States, right? They just got themselves three steps backwards. And what's been happening to China? CNY’s stronger. The daily fixes have been stronger than the market expected. So the second big, we think, asset price implication is currencies, including CNY, you have to be looking at upside risks. It's not just that they could be sideways or not devalue as much as you expect. They could be revaluing. This is a big phenomena.

The third point is, I think the third implication for asset prices is, if this is the correct framing, if this is an unwind of 20 years of massive external surpluses on the part of EMs, so the Net International Investment Position would be a popular way of measuring it, do they own more of us than we of them? And the answer is yes. For China or Thailand or Philippines, if you map the NIIP, the countries that own more of us than we of them, against FX moves this year, you'll see a really, really good match. That's what's unwinding here, and whether it's because FX is being implicated directly in the negotiations, namely you cannot devalue it, or it's because the market is simply reacting to a reality that this system is over and that these surpluses are going to be unwound and that the countries with the surpluses are unwinding them, which only means selling dollars, whether it's one or the other mechanism, the most important point is this is an unwind of decades of accumulated surpluses, which can only mean dollar selling.

So what do we think investors should pay attention to in this very uncertain and tumultuous period? There are two key asset prices right now. First is the US 30-year, maybe the 10-year. But US is a poster child for our thesis of fiscal dominance, namely a country that has so much debt that monetary policy becomes irrelevant. The rising 30-year rate followed a downgrade from Moody's and is fitting in with this story of the end of US exceptionalism, that all investors are, to one degree or another, reducing their exposure to dollar assets. That's a real story, and it has implications mainly for G10 rates, not EM rates. G10 rates are highly correlated with each other, which is why the sell-off in Japanese rates was really fitting in with the sell-off in JGB rates and Japanese rates.

The real story, we think, is the right framing is these are both DM countries that are over indebted. And it's sort of a race to the bottom. And that's the way you gotta look at it. What’s most interesting is that rates are not selling off. They're rallying. So one key asset price to look at is the 30 year for clues to this. But we think the overall picture is DM losing, EM winning. The second key asset price to watch is CNY.

All the cool kids, the folks we respect with maybe one exception, think CNY will go weaker even to this day. It's a big consensus view. There are shorts in it. We think it is completely wrong as we mentioned in another portion of this discussion. We think there's risk of CNY revaluation. We think this will augur the era of EM exceptionalism. The era of exceptionalism is really what we're witnessing right now.

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