JPMorgan’s Michele Warns Mighty Dollar May Trigger Next Crisis

(Bloomberg) — Bob Michele, the outspoken chief investment officer of J.P. Morgan Asset Management, has a warning: the relentless dollar could forge a path to the next market upheaval.

Most Read from Bloomberg

Michele has been in de-risking mode, sitting on a pile of cash which is near the highest level he has held in 10 years. And he is long the dollar. While a market crisis sparked by the greenback is not his base case, it’s a tail risk that he is monitoring closely.

Here’s how it could happen: Foreigners have snapped up dollar-denominated assets for higher yields, safety, and a brighter earnings outlook than most markets. A big chunk of those purchases are hedged back into local currencies such as the euro and the yen through the derivatives market, and it involves shorting the dollar. When the contracts roll, investors have to pay up if the dollar moves higher. That means they may have to sell assets elsewhere to cover the loss.

“I get concerned that a much stronger dollar will create a lot of pressure, particularly in hedging US dollar assets back to local currencies,” Michele said in an interview. “When the central bank steps on the brakes, something goes through the windshield. The cost of financing has gone up and it will create tension in the system.”

The market probably saw some of that pressure already. Investment-grade credit spreads spiked close to 20 basis points toward the end of September. That’s coincidental with a lot of currency hedges rolling over at the end of the third quarter, he said — and it may be just “the tip of an iceberg.”

Michele, who’s endured every rout from Black Monday and the dot-com crash to the 2008 crisis and the pandemic, has made some key calls recently that proved prescient. A year ago, he warned that inflation would be stickier than many market pundits thought and the Fed would raise interest rates much sooner than 2023, as was priced in at the time. He held on to cash at the start of this year, sidestepping much of the turbulence in stocks and bonds.

Michele’s central view is that the Federal Reserve will continue to raise interest rates at a more aggressive pace than the “complacent” market is pricing, bringing the Fed funds rate to 4.75% and leaving it there until inflation approaches the 2% target.

The central bank will be so committed to combating inflation that it will keep raising rates and won’t pause or reverse course unless something really bad happens to markets or the economy, or both. If policy makers pause in response to market functionality, there has to be such a shock to the system that it creates potential insolvencies. And a rising dollar might do just that.

Barring a deep recession — think several quarters of minus 3% to minus 5% GDP here — or a serious market crisis, or both, the Fed is unlikely to budge, Michele said. The US central bank has raised its benchmark by 75 basis points three times in a row and comments by Fed policy makers suggest they’re on track to deliver a fourth such increase next month.

The latest data suggest the Fed may still have a long way to go. Consumer prices in the US rose 6.2% in the year ending August, the 18th consecutive month of annual inflation above the 2% target. US employers added 263,000 people to payrolls in September, an indication that underlying demand remains sturdy.

Higher Hurdle

“The Fed is very clear that they want to get inflation back to 2%. When you start piecing everything together, rates have got to go higher than where they are, and they are going to stay there for a while,” said Michele. “They will pause but the hurdle for that is getting much higher.”

Here’s how Michele is safeguarding his portfolio:

He is underweight credit, and takes any rally as an opportunity to further reduce the holding.
He has also cleaned hybrid securities from the portfolio, and favors high-quality, highly liquid bonds that can withstand a deep recession.
Most of the cash he holds is put into the front end of the money market — one-year high-quality investment-grade corporate securities or very short-dated securitized credit.
Michele is long dollar against core currencies
Government bonds are starting to look attractive, but they are not at levels Michele would buy yet. He would wait until 2-year Treasury yields climb to 4.75%-5% and 10-year yields to 4%-4.25%.

“We have spent most of 2022 ensuring that every single holding in our portfolios could survive a material downside shock,” he said. “While prices have reset lower, there is still plenty of liquidity in the market for now. But what if, with the benefit of hindsight, the first nine months of 2022 prove to be the calm before the storm?”