Advertisement

Debt ceiling debate and its effect on the U.S. dollar

Citigroup Global Markets Head of CEEMEA FX Strategy Luis Costa joins the Live Show to discuss the impact of a strong dollar on emerging markets in developing nations, China pushing Yuan to be the global currency, and the potential debt ceiling default's impact on the U.S. economy.

Video transcript

- Call it the world's most painful trade dollar strength, or at least not more dollar weakness, has been an ongoing story the last few months. Despite markets pricing in a June rate pause and eventual cuts, inflation is gradually cooling, which should weigh on the greenback, but we haven't seen that. A regular victim of a stronger dollar or emerging markets.

Just look at Argentina, which is essentially running out of cash, as it looks to stave off inflation and prop up its peso. The Turkish lira is another victim and hit a record low against the dollar this week. When the dollar rises, developing nations usually go all in to defend their currencies against steep falls. The reason is often to protect dollar denominated debt from becoming unsustainably expensive. Of course, Argentina and Turkey also have their own idiosyncratic political and economic issues. But the dollar does not help.

Let's take a step back and look at the wider impact here. Luis Costa is Citigroup Global Markets Head of Central, Eastern Europe, the Middle East, and Africa FX and Rate Strategy. Luis, thank you so much for being here. So when we look at the dollar versus these other currencies, and we look at in particular, how the markets have responded, do you expect that sort of trend to continue? In other words, do you think the dollar should remain relatively resilient, and therefore, maybe those other currencies not so resilient in this environment?

LUIS COSTA: I think this is the hottest topic now when we discuss emerging markets, generally speaking, with our clients, right? It's the change of broad, we call the broad dollar assumption. I mean, if you go back to the beginning of the year, the theme was a lot more in favor of a weaker dollar. And then we had the anatomy, the anatomy of the markets was actually pointing this way. We had a very decent divergence between the US data and European data. The European data a lot firmer, especially when it comes to the sentiment side.

And most importantly, and your colleagues already mentioned that the China assumption was quite different. We were right in the middle of just China reopening theme. And I think that's-- I mean, some of the sectors I mentioned, they are kind of imploding now, right? I mean, it's quite interesting. To the latter case, with the China growth assumption is changing quite a lot. Obviously, it's probably still the case that they're going to achieve 5 and 1/2, 6% real GDP growth this year. But when on a quarter over quarter basis, it's looking on a more high frequency basis. Growth out of China is looking quite tepid.

And most importantly, the renminbi is also losing traction, right? I mean, depending on how you look into the equity gauges, we are pretty much wiping out the gains and some stocks or some indices out of China. So I do think that I mean, some of these factors are changing. And it's probably pointing towards a lot more to weigh in the dollar. Not necessarily a huge dollar mini cycle here or bullish dollar mini cycle, which as you mentioned, can be very detrimental to EM risk. But I mean, it's definitely more to weigh here, and it calls for better homework when it comes to getting involved into EM now.

- So to your point, Luis, Diane here, there had been I guess some talk about the rise of the East, and is the dollar's dominance, like are the days numbered? And to your point about the issues with regard to China's Yuan. Is there a point where we could see that happening more, emerging markets like China, especially since they are pushing for a change to the world reserve currency. What could happen? Like does this debt ceiling debate start to jeopardize the strength of the dollar?

LUIS COSTA: Well, I mean, it's an interesting question because we have seen, there has been a secular-- and we've have written extensively about that. There has been a secular move out of dollar. But I mean, we have to discuss the size of this move out of dollar, right? I mean, knowing that of course, I mean, it's still US assets or US treasuries. They are still amply known and regarded as the safe havens for any FX reserve manager out there. So it's very difficult to get out of treasuries and try to hide somewhere.

And most importantly, I think we are also moving-- we are right in the middle of this different cycle the way international managers see the Chinese market, right? I mean, you probably remember seven, eight years ago when they were trying indeed to open up the markets, open up the capital accounts to international investors. There was a frenzy, right? There was this impetus to participate now, which is a very large liquid market, right?

But we know that, even because of the geopolitical aspects, that lost a lot of traction. So I still find very difficult to believe that this is going to accelerate. Obviously, there's an attempt to diversify assets by FX reserve managers. But not strong enough, not powerful enough to change the dynamics of the dollar for those investors.

- And in terms of the geographies under your purview, are you finding areas that are indeed attractive that are good alternatives right now?

LUIS COSTA: Yes. We still find. I mean, in the emerging markets currencies, and as I mentioned to my clients, it feels like the broad dollar assumption is changing, but it doesn't necessarily mean that investors should just flee emerging market currencies. You still have interesting plays.

I mean, Mexican peso is an interesting play. Brazilian real is an interesting play. There are currencies that are still holding a decent amount of carry, right? The differential between the local interest rates and US interest rates. And most importantly, the real rate valuation. So when you take into account whatever interest rates that currency is paying versus inflation.

So especially Latin America currencies, and I mentioned a few examples. The Brazilian real or the Mexican peso, they are still interesting plays. But as I said, the homework has to be done a lot better now. I mean, in emerging Europe, the story is quite different because this is a group of currencies that never quite offer enough real wields, never quite offered enough carry, and with a few exceptions.

So I mean, I think it's the story is definitely, as you mentioned, the geographical differentiation, that the story remains quite biased towards LATAM currencies still.

- Gotcha. Luis, thank you so much for your perspective this morning. Luis Costa is Citigroup Global Markets Head of Central and Eastern Europe, Middle East, and Africa FX and Rates Strategy. Thank you.