ED HARRISON: Hi, I'm Ed Harrison, your host here for Investment Ideas. We're going to talk to Marc Chandler, who's a principal at Bannockburn Global Investment. And he's going to talk to us about foreign exchange, which is a locus of a lot of volatility recently. His thesis, when we last spoke to him, was about the dollar rolling over and hitting an all-time high. However, we want to talk to him not just about the dollar, we want to talk to him in particular, about what's going on with the Chinese yuan, and all of the currency volatility there, as well as what's happening with Brexit. Hope that you enjoy it.
Marc Chandler, it is a pleasure to have you back on Investment Ideas. And I want to talk to you some things have happened in your market since we last talk. I guess the first thing is in your macro thesis, how's it changed in the interim before we get into some of the intricacies of what's changed in the time period?
MARC CHANDLER: Sure. So I still am in a camp that says that the dollar is big rally that began maybe 2008, 2009. The Euro was at a 1.60, Sterling was above 210 in 2007- 2008. And I think that that 10-year bull market for the dollar is over. And I think that even if we make a modular new low out of bilateral currencies, when I look at these, the Federal Reserve that is real meaning adjusted for inflation, broad meaning it's inclusive of all of our trading partners, dollar index. And this really lines up very well with the Euro, in fact.
For me, this end of this third dollar rally and the event were saying we're about to celebrate the 40th Anniversary of the Bretton Woods. And so I'm thinking that the three things that have taken place that make me think the dollar has turned. First is the policy mix. I'm really a big follower of the policy mix. And what we had in the US was loose fiscal policy, and tighter monetary policy.
And now, we've gone to the exact opposite. The tax on imports coupled with tighter Fed policy. We really reversed this policy and that policy mix is no longer supportive for the dollar. Second thing is I've noticed in my work, of course, a small sample size, because we've only had these two other dollar rallies. But then in the last phase of a dollar rally, the interest rate differentials move against it. It's like in the early phase, you say, well, I need a stronger dollar, because I get a worse return on the assets.
But nine or 10 years into a bull market, you say I don't need to worry about the asset because I got the dollar at my back. And so, the interest rate differentials moved against the US since November, against US-Germany, US-UK, US-Japan since last November. So we're talking about something that's not just a one- week move or a one-month move, but we're talking about sustained move here. We got the policy mix, you got the interest rate differentials. And one place I would agree with President Trump is that the dollar is overvalued.
If you look at like the OECD currencies, the rubber band that connects their value to price can be stretched. Well, how far can it stretch? Well historically, it doesn't get stretched much more than 25%. Today, the Euro is about 23% undervalued, Sterling is about 20% undervalued. So I think the rubber band is stretched just about as far as you can go.
ED HARRISON: Interesting. A lot of the volatility that we've seen are not necessarily in the complex like Sterling and the euro. Actually, I want to come back to that in a second. I want to talk a little bit about China and Hong Kong, because that's what's on everyone's mind. And when you look at the broad way to Dollar Index, China's obviously a part of that. But what we're seeing now is that the Chinese currency is depreciating against the dollar. From your perspective, what's going on there? What's different about that? Because they have a crawling peg that's at work there.
MARC CHANDLER: Yeah. Of course, everybody got to follow China. I think it is the US trade ties with China, that whole relationship, I think is the key thing for the investment community right now. I think it really directs the Fed policy in many ways. I think China, and what's going on is very important.
I think that China's got this tough position. The economy is getting worse, partly of its own like internal dynamics, and then you got to trade stuff on top of it. And so in a floating currency, if the currency were really to float, it would be a genuine floating currency, I think it'd would have sunk much more than it has. And so, Chinese officially I think are leaning against it. But I think that the 7.0 level that we've got really excited about last week is really more of a psychological issue.
Give you a sense of this, the year to date- so through the first eight and a half months of the year, the RMB has lost about 2.50% of its value. I don't think that's big enough to offset the trade tariffs. I don't think it's enough to really boost China's export competitiveness. I don't think it's enough to really like ease Chinese monetary policy.
I think that this is just a little bit of fluctuation, which I think the Chinese want to have. I don't think they want to have a pegged because they are slowly, or maybe sometimes quickly, being integrated in the world capital markets. And having a flat currency I think teaches people bad things like not hedging currency exposure.
ED HARRISON: Well, tell me about that. Two things on that. First, before we go into the hedging currency exposure, if I'm taking you correctly, basically, what you're saying is, is that the Chinese government is saying, we want to get rid of 7.0 in people's mind. People are thinking 7.0 against the US dollar. No, we don't want that. We want to eviscerate that concept. But we're not going to depreciate our currency tremendously.
MARC CHANDLER: Exactly. I think that's exactly what happened. I think that the Chinese have had this as a goal- let's remove the magical miss, the enchantment people have with the 7.0 level. And how can they do it? Earlier this year, people say how can China get away from- how can they get away from this? And so China figured out a way. They used the latest round of Trump's tariff threats. And they said, okay, we'll let the 7.0 go, and we can blame the US.
And it is perfect, because I think they just followed. Like, it's really like a weird dance. What the US did was it cited- after China like moved its currency above seven, the US knew that it's not a very significant thing. And so what they did is they said, okay, China, you're going to be guilty of currency manipulation, which is a toothless policy. China knows it. The US knows it. That there's nothing that happens now. We're supposed to negotiate with China. And so that's what we're doing.
And now, we're going to negotiate under the auspices of the IMF. And the IMF comes out with a report recently that says that China's not guilty of currency manipulation, say China's currency is roughly fairly valued. Yes, they want China to do more with liberalization. But they don't have a problem with Chinese currency manipulation.
ED HARRISON: What about the liberalization? Is that going to happen? Is that positive or negative for China? Do you think that they're going to liberalize anymore?
MARC CHANDLER: It's definitely a country- I want to say a small country like the US with a 375 million people, China's got something like 1.3 billion people. And I think that you have an economy that size, without a lot of the institutional mechanisms that we have, they're very much loathed to give up control. And I think that here we are in New York, but to the capital of the capital, if you will, where we make a virtue, we make a set of virtue out of necessity. We have floating exchange rates, because we don't want to keep fixed exchange rates together. And I think that China, most countries don't really fully embrace floating exchange rates.
Look at the two largest traders in Europe- France and Germany, they tried all kinds of mechanisms to reduce the volatility until they decided, let's have a common currency. Japan's never been a full believer in floating currencies. Many emerging markets are not. So I think that there's only a handful of countries that are true believers in floating exchange rates. And I think that China, so China side with the majority. That currency price that's so important, they shouldn't be left simply to speculators.
ED HARRISON: So you're saying that we're going to continue with this crawling peg. But the question is, is what level will we get to at the end of all of this? Now, when we're taping this, we're looking at the ground peg moving from like 692 to about 703. Where do you think it's going to go from here say by the end of the year?
MARC CHANDLER: I think we're about halfway to what we're going to see. And that is to say that maybe another couple percent, maybe we're talking about 710, 715, something of that area this year. It's not a big move, but I think it matches China's China Ease Policy. I think that number of reasons why I think China would allow to weaken a little bit but not a lot. And you don't want it to weaken a lot I think from China's point of view, because you taper, it doesn't help exports, it does. But the problem really is, again, it's really the capital flow part of it.
What China wants to avoid the repeat of 2015. They got capital controls in place, which should help but they keep arresting people for violating these capital controls. And so I think the EF capital that shows you got all these ways of gaming the system. But I think that China would accept a modest depreciation of their currency.
ED HARRISON: And what do you think about this, going back to that issue we're talking about in terms of teaching discipline to people who are not hedging? My understanding is you were talking about Chinese companies not hedging their foreign currency exposure. Talk to me a little bit more about that.
MARC CHANDLER: Yeah. I think that this side of it is very important because, for me, it's not so much the goods market. That's what we all talk about, trade and of course, to the trade war. It's hard not to. But for me, it is really like the capital markets. They're huge. The foreign exchange market $5 trillion a day average daily turnover. So world trade in a year is no more than $30 billion.
We're looking at a huge foreign exchange market. I think that what this means is that China, probably, why they moved to 7.0. The importance here is not about boosting trade. But a lot of Chinese companies, they borrow dollars, or sometimes Euro, because oftentimes, it was easier, cheaper. And so they borrow these, but they did it on unhedged basis, because the Chinese currency is pegged to the dollar, isn't it? With their mentality, with their thinking.
In the long run, it makes sense for China to help facilitate Chinese companies to move up the value chain, and learn more about hedging currencies and being able to really operate in the dynamic world economy in which they're like entering. And so I think that the problem is that something of the magnitude of $800 billion of foreign debt is now in Chinese books, corporate books. If they allow the currency to depreciate too fast too much, it's really going to hurt those companies, which then hurts the economy, which put them back behind the eight ball. And so my sense would be that Chinese officials want to weaken the currency, not to really offset tariffs or to boost trade, but to really, it's a financial capital market issue.
ED HARRISON: Interesting. So, boost it enough or depreciate the currency enough to give a sense of market discipline and move these companies in the direction that they're looking over the long term?
MARC CHANDLER: I think so. That seems, to me, to be- if you try to make sense out of what they're doing. So you have to assume I think when we do these kind of things that they're rational actors. And so, that's the only way I can see how what they're doing makes sense.
ED HARRISON: Well, let me take that- the whole concept of China and let's put it into the Hong Kong scenario, because we've been talking about the exact same thing with Hong Kong. The peg. The question is how do you defend the peg? And is it defensible? We've had people in Real Vision talk about that peg falling away. What do you see as the dynamics around Hong Kong, particularly given that it is the conduit of capital between the rest of the world and China?
MARC CHANDLER: Yeah. I would take China's word that when they took back Hong Kong, they basically promised not to screw up the Hong Kong regime for 50 years. And we're not too far into it. And so, I think that the peg in Hong Kong, Hong Kong and Chinese officials have shown that they'll do anything to defend it. Remember the '97-'98 crisis where the Hong Kong Monetary Authority ended up buying huge amount of stock, of equities to support, to keep the money inside the country.
And I think that's what China's point of view. I don't think Shanghai is yet big enough or significant enough in the world stage to replace Hong Kong. So I think that eventually that's going to come. But I would want to bet against the HKMA and the PBOC keeping that currency pegged.
ED HARRISON: And what about the unrest? You don't think that that's going to somehow create a sense that they're violating the treaty that they signed to say that we're going to make Hong Kong autonomous, and that undermines Hong Kong as a conduit, as a place of financial center in Asia?
MARC CHANDLER: Yeah, no, I think in the short term, the peg holds. In the longer term, though, medium term, I think that Hong Kong's role will be diminished. I think I'll be looking for certain signs, for example, I might watch property prices. If I see Hong Kong- Hong Kong is an island, doesn't have a lot of property. They keep trying to make more of it.
But if I see property prices beginning this fall, they told me people are selling, people that want to leave, I see people trying to leave Hong Kong. And so as this happens, if I'm right and these things materialize, I think that Hong Kong's role will just slowly diminish. People look for maybe it's Singapore becomes the Asian Financial Center outside of China.
ED HARRISON: Interesting. Speaking of diminishing roles, let's move to the UK because they are looking to have a potentially diminished role. And we were talking earlier about the British and the Euro trading at ridiculously low levels. A lot of that for the UK is particularly because of Brexit. And that's the risk there, associated with that. Where do you see the sterling heading over the next time frame? And what's the political backdrop to that?
MARC CHANDLER: Yeah, sure. In foreign exchange, people are often looking for trends. And I have a lot of my friends complain there's no trends and foreign exchange. I'll tell you what, it's still here today. For the past 14 weeks, 14 consecutive weeks, the Euro has visited against Sterling. What's going on Sterling, of course, it's falling into the dollar. We're trading close to 1.20 now. Like I mentioned back in '07-'08, we were at 2.20, 2.15, that kind of area. So we've dropped a full dollar in Sterling.
And so I think what's happened with the Brexit ever since it became clear that Johnson will become the Prime Minister, and that he was adamant about leaving with or without a deal. And given his confrontational stance, many people are judging that one, he's serious. UK will leave at the end of October. I watched that at predicted.org. And they have, for the first time, they have over half the people who are playing that market thinking that the UK leaves on October 31st. So this is the big shift from say when May was Prime Minister.
But I think what's happening now is the market is just saying that Sterling outside the EU is not worth with Sterling inside the UK, inside the EU's worth it. Ad so, they're marking down and they take the currency down. They're marking down all of UK assets. And I think that people realize- even if some of the British don't, that the country's probably going to be poor on the other side of this, whatever this is.
ED HARRISON: The thing is that is a onetime event, a onetime hit. You could make the argument that if the currency does most of the adjustment for the UK, that actually post-Brexit, it won't be as difficult. Do you buy that argument?
MARC CHANDLER: Well, I think that there are some moving parts. For example, one of the things I think could happen, so the scenario would be this, the US- Trump follows through with his tariff on autos, and then gives the UK a free trade deal that excludes autos. That is to say that Europe has to rebuild cars in the UK to export them duty free to the US.
I think that there's a lot of moving pieces here. But I think that here's what's going to happen. This year, I think India is going to surpass the UK of size of GDP. So the UK is slowly falling down the ranks. India I think will