When filling out our March Madness brackets, we tend to bet on the heavy favorites. Most of the No. 1 seeds have gone far, just as expected. This is perhaps more true than ever this year, given Kentucky’s undefeated season. But we also had to be mindful of the bracket buster — the unexpected team that could upend the entire picture of what should happen.
This spring we could see a bracket buster in financial markets. Right now, there is an expected path the global economy is supposed to take. The European Central Bank (ECB) and the Bank of Japan continue quantitative easing to nurse their economies back to health, and, with low oil prices keeping inflation benign, the Federal Reserve also remains accommodative.
This is still a likely path — a long run by the No. 1 seeds, if you will. There is another bracket buster looming over the financial markets, though, that’s worth watching.
There was some puzzling behavior within financial markets this past week. Equity markets sold off, particularly in some of the most heated pockets of the market, suggesting a risk-off environment. But demand at Treasury auctions was weak, and the U.S. dollar also lost strength. These curious movements may be the result of a missing buyer of dollar-denominated assets. The oil price collapse has led to a steep drop in the net trade surplus of oil-producing nations, that is, in so-called petrodollars. In 2006 $500 billion worth of petrodollars was circulated back into dollar-denominated assets. Today that number stands near zero. Although it’s not our base-case scenario, there could be some rather big — and unexpected — consequences as this source of demand for dollar-denominated assets disappears.
The consequences could be a weakening of the U.S. dollar that is remarkably different from consensus predictions. Amid this backdrop, it could prove more difficult for the Bank of Japan and the ECB to competitively weaken their own currencies. If markets lose faith in the ability of these two central banks to carry out their intentions, it could wreak havoc on financial markets.
The absence of petrodollars could take the Fed by surprise too. If the dollar loses some strength, the U.S. economy could start to see inflation. How ironic would it be if low oil prices were inadvertently to spark inflation? The Fed might have to react faster than the market has assumed. Markets have been volatile enough on pure speculation of what the Fed might proactively do to stay ahead of an increase in the price basket. Imagine how markets would respond if the Fed were suddenly in a reactionary position.
Again, this isn’t our base-case scenario. But it is worth noting that option markets signal that the risk of the dollar actually weakening is increasing. Over the past few weeks, the option prices have implied increased downside risk to the U.S. dollar as measured through the option skew, which compares the price to protect the downside, or puts, versus the price to participate on the upside, or calls.
Of course, the dollar could once again strengthen. After all, monetary policy in Europe and Japan has created no shortage of dollar buyers abroad. But if the market is fully pricing in these activities, then the Bank of Japan and the ECB no longer become price setters. The marginal players that could become the price setters are the holders of petrodollars. Given the amount that has historically been in the market, these aren’t your average small-school bracket busters. They could make for some real market madness.
Ashwin Alankar, based in Denver, is senior vice president, head of asset allocation and risk management for Janus Capital Group and co-manager of the Janus Global Allocation Funds.
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