ED HARRISON: Welcome back to Investment Ideas. I'm your host, Ed Harrison. And today, we're going to be talking to Marc Chandler, who's the chief market strategist at Bannockburn Global Forex. We're going to be talking to him about what to expect in the currency market now that the Fed has moved to a Douglas policy. So let's get right to Marc.
Marc Chandler, it's great to have you on Investment Ideas. I think I was telling you earlier that this is a show where we're going to be talking about, say, the 6- to 24-month time horizon. That's the kind of thing that we're talking about. But when we were talking, we were talking more towards the shorter end of that horizon in terms of currencies. Tell me-- what are you looking at in terms of foreign exchange currencies? What's the thing that's dominating your thinking over the next six months?
MARC CHANDLER: Yeah, so for me, we're still in the middle of the third big dollar rally we've had since the end of Bretton Woods. We had the first dollar rally-- it was a Reagan-- really Reagan and Volcker. The combination of Volcker tight monetary policy, the US had double-digit inflation. And Reagan, despite us thinking of him as a conservative, he was increasing defense spending, increasing social spending, cutting taxes, leaving a very large deficit.
So this fiscal expansion, monetary tightening, led to this big dollar rally. The G7 thought the dollar had gone far enough in the mid-80s, and they met at the Plaza Hotel here in New York. Now, it's condominiums. And they agreed to intervene and drive the dollar down and set us up for a 10-year bear market.
And then we had the tech bubble. So we had a Bill Clinton in the White House tech bubble. But that wasn't enough yet to keep Americans keeping the money at home, foreigners buying American assets. We had Robert Rubin come into the treasury and began, in the mid-90s, this strong dollar policy, which really means that a lot of people are confused about it.
We've had a vice president who said a strong dollar policy meant that the dollar was difficult to counterfeit. Robert Rubin meant by "strong dollar" was that the US wouldn't weaponize the dollar. We wouldn't threaten, like we did previously under Clinton as well as under Bush and Reagan-- threaten our allies with letting the dollar depreciate to get some trade advantage or to possibly even reduce our debt burden.
So we had a 10-year-- we had the second big dollar rally. The Bill Clinton, Robert Rubin dollar rally lasted from '95 to about 2000 because what happened then was the euro was born. I always thought the Europeans had a common currency. I thought it was American Express. But they decided to have their own individual currency, the euro.
And when the euro was born at around $1.19, it immediately fell to about 82 and 1/2 cents. And the Europeans said-- even though people were buying the dollar-- the Europeans said, quit picking on our euro. Hence, they organized a round of coordinated intervention in October of 2000. It set the dollar up for another prolonged bear market.
And now, I think we have the Obama-Trump dollar rally. And I think that rally is driven not by the policy mix that we saw under Reagan and Volcker, not under the tech bubble that we saw under Clinton, but really by this divergence. The US was the first in the crisis, the epicenter was here. And you might not have liked with the Federal Reserve or the Treasury did, but they took aggressive action-- first ones out.
So I think the dollar's still riding those fumes, if you will, this divergence, which remains intact now even.
ED HARRISON: That's interesting that you were saying the fumes, because that's what we're talking about in terms of the six-month horizon-- is it's that we're actually at the end of that cycle.
MARC CHANDLER: Well, I think that what we had really-- this Trump-- Obama-Trump dollar rally, I think it has three parts. The first part was the pure divergence, the Federal Reserve, the economy recovering faster than many others. Federal Reserve being able to raise interest rates before other countries.
The second phase really began with Trump. And I think it would have happened under Hillary Clinton as well. Both of those candidates in 2016 promised fiscal stimulus. Trump gets elected, he delivers big fiscal stimulus. So we have this policy mix again as a second part of this third dollar rally. But now that that fiscal stimulus has mostly worn off, we still have the dollar strong because the US economy appears to have emerged from a soft patch faster than Europe. We're still seeing the European PMIs contracting, and purchasing managers surveys contracting. The Japanese reported purchasing managers for a March contracted. The US economy looks like it's growing above trend, despite the hit we took earlier on in the quarter.
ED HARRISON: So basically, at least over the short-to-medium term, you think that the dollar's going to continue up? How are people positioned in the markets vis a vis that trade?
MARC CHANDLER: When I read a lot of the other analysts, I see a lot of people who are very bearish on the dollar. They keep thinking the dollar is going to fall. But when I look at market positioning, what I'm interested in now is not the commercials, businesses that have an underlying business need. But I'm looking at the people who have discretion. The CFTC calls them noncommercials. I call them speculators.
And the speculators have a very large, long dollar that is short foreign currency positions. So the market's position for further dollar gains, and I think that we'll see those. I think that-- so the dollar index would go to, say, 100-- puts the euro at, say, 110.
ED HARRISON: So you're talking about DXY, the Dollar Index?
MARC CHANDLER: DXY to 100. We're sort of testing this 97, 97.50 area. So it's a couple more percentage points higher. The euro, we've been a-- this 111, say, 85, here, is a major technical-level retracement. But I think we go down to 110 still, so there's more legs there.
I think we can see a Dollar Canada go up to 136, 138. So I'm looking for, in the next six months or so, maybe towards the end of the year, another leg up in the US dollar. And I think that could be the last leg of this three-part, Obama-Trump dollar rally.
ED HARRISON: Let me bore into that because when you talked about the fumes of this third dollar rally, to me, that has the hallmarks of-- that's where the change is going to happen, sort of a rolling over process-- not necessarily in six months, but in the time horizon that we're talking about. What's going to drive that process?
MARC CHANDLER: Well, I think a couple of things. One is that I am concerned that even though the US economy recovers from this soft patch, I'm under the candidate that says we're on the verge of recession. I see above-trend growth for the next several quarters.
But I do think that as we approach early 2020, I think the US economy will weaken again. And I think that by then mean the Fed easing in, just as Europe might be finding some better traction. And so I think that, for me, I missed this in 2017. I knew it, but I'd sort of shrugged it off.
And that is-- when it comes to stocks, we have some agreed upon models of valuation. But the closer we come to currency, there's something like purchasing power parity. And typically, I look at the OECD's model so I don't have to reinvent the wheel myself. And I find that most of the time, OECD currencies don't move much more than 20% plus or minus their purchasing power parity level.
And what happened in late 2016, early 2017, is the euro reached about 30% undervalued. And that told me that it should bounce. But I sort of played it out. I thought this time could be different. And here we are. As we sit here today, the euro is about 25% undervalued again.
And so you say, what's going to happen? I think, well, the valuation snaps back because the market's positioned for good news for the US, bad news for Europe. And I think that over time, what happens is that we begin expecting this good news and it's harder and harder to surprise us.
While the European bad news is known. It's seen to be structural. It's a permanent kind of thing. And that's just when I think things begin turning.
ED HARRISON: Very interesting. So basically, over this shorter term, yes, the position of long is good. But then, you're going to get this rolling over and then you're going to have a reversion to the mean effect as a result of the things that you're talking about.
MARC CHANDLER: Even now, the interest rate differential, which I put a premium on-- trying to understand narrow, medium-term moves in currencies, thinking that currency is the price of money. So are interest rates. And the interest rate differential between the US and many other countries is historically as wide as it's been in history or it's 20 or 30 years wide. And I think that it's too extreme, and that capital has a way to adjust this. Like water flowing-- so does capital.
ED HARRISON: Let's talk about some of the things that are going to happen in 2020 and beyond. So to the degree that you're going to have this reversion to the mean, it's going to be as a result of the US underperforming relative to expectations, and Europe potentially outperforming and other countries like that. Does that mean recession, potentially, in the United States?
MARC CHANDLER: I think this is the thing. For me, we're still in this Great Moderation. A Great Moderation is longer business cycles, and flatter-- not high-highs and not deep, deep troughs, with the great financial crisis, of course, being this exception to the rule, if you will-- quite an exception. But I think the business cycle is longer, but we haven't repealed it.
And so I do think that the big fear is that the next end of the business cycle is also a financial crisis. I don't think that's going to be the case. I think we get a shallow recession because the structure of the economy has changed. So for example, the service sector is much larger and it's less cyclical than a manufacturing sector. And we've learned better management techniques like just-in-time inventories, which also help smooth out the business cycle.
This could be another technological development in the 20th, 21st century of managing the economy-- not only managing economy from the Federal Reserve's point of view, but companies know how to manage their inventories better, manage their finances better. They have more tools available.
So I do think we get a recession because the business cycle hasn't been outlawed. But we get our-- it's a business cycle that's just a shallow recession, leads to, possibly, a Fed rate cut before the 2020 elections.
ED HARRISON: Let me ask you-- with regard to previous cycles, what does this look like as compared to previous cycles because I know when you look back, it was a cycle that ended in a financial crisis. But we saw the dollar move to a very large high in the last cycle. Is this cycle different in terms of when that happens and what happens afterwards?
MARC CHANDLER: The Reagan dollar rally was the biggest.
ED HARRISON: Mhm.
MARC CHANDLER: The Clinton dollar rally didn't get to that peak. And it doesn't look like the Obama-Trump dollar rally is going to get to the Clinton peak. Initially, I thought it had the legs to do so. But it looks like less likely now to me that we get to that Clinton peak. So what it looks like then, take a long-term view, is the dollar's peaks are lower and lower.
And it makes sense as far as we know about-- what we know about the world. The US share of world GDP is shrinking. Emerging markets is rising. I think that's an interesting thing that's happening-- is that we think about the major country that is dominating the size of the world economies, but as you know, China's moved up to number two and India is already at number five. And so in effect, I think, more pressure on Europe to get their act together.
Sort of like-- talking about Benjamin Franklin before. And one of the quotes that I like of his-- he says, he tells the 13 colonies, you either hang together, or you hang separately. I think Europe faces that same choice.
ED HARRISON: You mentioned EM, there-- Emerging Markets. Let's go away from Europe and all of the big countries. What's going on there? What seems interesting to you outside of the dollar play?
MARC CHANDLER: I think that in some ways, you get this trilateral view of the world, in effect, where East Asia is increasingly moving into China's orbit. The role of the Chinese market-- both imports and exports. Many countries in East Asia, even countries that the US invented, like Taiwan or South Korea, have moved where China is their biggest trading partner. And I think we're going to see China's tastes and flavors and preferences, consumer preferences, shape a lot of the products that we have going forward, including electric cars, for example.
I think that Eastern Europe is moving into the German or-- the eurozone to orbit. That's German manufacturing. So it's not really a clean play. I like that they're looking at Eastern and Central Europe.
When they were apart of the Soviet Union, they couldn't wait to join the EU. It was a sign of modernization, democracy. And now that they're in the EU, they gripe about how liberal it is. And people talk about, well, maybe they should be in it anymore. So I think there's some interesting economic developments in Poland and Hungary that are interesting for its own right, besides being moving into the European orbit.
Closer to home, I think we've had some-- Latin America has really been amazing. If you think about what's happening in Argentina, Brazil, and Mexico. Those are the three big countries there. And I think Mexico is moving increasingly into the-- tied more into the US, even if this NAFTA 2.0 doesn't get passed. I worry that it won't be passed.
ED HARRISON: What do you think this means for the Mexican currency?
MARC CHANDLER: Yeah. So I think Mexico has really high yields. And I think this is what's attracting a lot of the leverage community like the hedge funds, the Mexicans' short-term paper. The yield is-- so they have a very high nominal yield and a very high real yield. And so you buy them because you think that the Mexican peso will hold its own.
And instead of holding its own, the Mexican peso is one of the strongest currencies this year, maybe up 4% or 5% against the US dollar. And you get a high yield on top of that. And what you're playing for is-- interest rates in Mexico will fall as the economy weakens under the pressure of these high nominal interest rates. And so as nominal interest rates fall, and real interest rates fall, your bond yields can fall as well, giving you capital gains. So not only do you get a high yield, capital gains, and an appreciating peso.
ED HARRISON: Very interesting.
MARC CHANDLER: I like the pe-- I like this place the most. But AMOL-- it's sort of what we were talking about before. In the US we have a center right populist. Mexico has elected a left populist. And investors seem to be quite comfortable with him, almost as much as they are comfortable with a right wing populist in Brazil.
ED HARRISON: Speaking of the right wing populist in Brazil, how do you think that the Brazilian currency and economy going to do over the medium term?
MARC CHANDLER: Yeah. So for me, the problem Brazil has-- it's really about their pension. In order to really free up policy choices, you need to have pension reform. And I just don't think the current president has the political clout to be able to do that, to do something that the other presidents have failed to achieve. Pension reform is the key. I don't think Brazil delivers.
ED HARRISON: At a macro level, we're talking about the dollar being strong and eventually rolling over. In terms of emerging markets, just broadly speaking, what does that mean in terms of-- what are the balances of a strong dollar in terms of how that impacts those currencies?
MARC CHANDLER: Yeah. So typically, a lot of emerging market countries do it. And it's easy for them to-- so my friends, they say, oh, it's imperialism or colonialism, these legacies. But here's, ultimately, the problem. These countries, who are independent, freely borrow dollars instead of bargaining on currency because oftentimes US interest rates are lower than in emerging markets. So many countries like Turkey, Argentina, Russia, even China issues dollar denominated bonds.
So you see a lot of dollar bonds. And all those dollar bonds aren't US liabilities. And these dollar bonds then, they work well when US interest rates are low and the dollar is weakening. But if the dollar gets stronger, US interest rates rise. This of course, puts them at a disadvantage. And so I think that a lot of emerging markets borrow dollars when their dollars were cheap. They were really suffering when the dollar get stronger. We have a lot of concerns about the debt burden of some emerging market countries. But I think a lot of emerging markets have pulled them. If you say, well, interest rates are lower, going to fall in the US, say 2020 or so.
ED HARRISON: Right.
MARC CHANDLER: Well, that might not be good for emerging markets if that comes with a weakening of the US economy. If interest rates drop because the US economy is in recession, it's not good for emerging markets either. So I think that the tension, where the lowered value of the dollar means it's easier for them to repay their dollar borrowings. But it's harder for them to earn the proceeds to pay back the dollar borrowings when they can't export so much the US.
ED HARRISON: But again, going back to your thesis of moderation, it doesn't sound like you think that's going to end in another emerging market crisis, especially given the fact that you see it topping out in the DXY.
MARC CHANDLER: Yeah. So I think that the emerging market-- it's hard to paint a broad stroke and say an emerging market crisis. Some countries can make poor decisions and they can compound poor decisions with more poor decisions. And that's what I think is going on in, say, Argentina and Turkey right now. I think could happen in Hungary.
But I don't think there's going to be an emerging market crisis, per se. I think that sometimes investors become a little bit more overweight to emerging markets as an asset class. But I don't think that's the case right now. I think that the emerging markets as an asset class can do all right, partly because of China higher commodity prices.
ED HARRISON: That is a very good view to take forward into the next six months, 12 months. Let's take a look and see, and maybe