There's been a shift in the way global markets are behaving

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In the space of two weeks, expectations for a US rate hike this year have gone from unlikely to a certainty courtesy of a raft of hawkish commentary from Fed officials and plenty of strong US economic data.

As you would expect, US yields have risen, as has the US dollar. However, on this occasion, risk assets are acting in a very different manner as to what we’ve seen in the past, at least so far.

Instead of wreaking havoc on stocks, higher-yielding currencies, and commodity markets, investors appear to have welcomed the news that a near-term rate hike from the Fed is on the cards, providing confidence in some parts that the risk-on, risk-off behaviour of prior years may be finally starting to dissipate.

Stock investors and those dabbling in crude oil, in particular, have been nothing short of bullish, buying in a relentless fashion in recent weeks.

Daniel Been, ANZ currency strategist, is one analyst who’s picked up on this switch in investor behaviour, suggesting that this may indicate that a stronger US dollar many not act as a destablising factor as seen in recent years.

“The recalibration of Fed rate hike expectations drove a sharp recovery in US real yields and a broad USD rally has taken hold. Despite this, the atmospherics around the current USD rally feel very different from those observed through 2015, and the shift has left us pondering whether we are observing the beginning of a new phase in the USD rally,” says Been.

Given this divergence from past trends, he believes that the US dollar rally may be entering what he deems to be a “third phase” where USD strength will become less of a destabilising force on broader markets.

“We think the first phase through 2014 was driven by policy shifts and cheap USD valuation. As such, the USD rallied uniformly. The second phase, in 2015, was characterised by the USD rallying against peripheral currencies, but exchange rates for the big current account surplus counties became far less predictable,” notes Been.

Although he is not yet willing to commit to the view that US dollar strength will not create carnage in risk assets as seen in mid-2015 and early-2016, he notes that there are several factors that suggest this time may be different.

Take the recent divergence between crude oil futures and the US dollar index, as an example.

As the chart below reveals, supplied by ANZ, there’s been a clear decoupling between crude prices and the US dollar in recent weeks.

Been suggests this development, along with stability in other asset markets that led the selloff in risk assets previously, is noteworthy.

“We think the relative stability in the CNY, oil price, and credit market are all sending potentially important signals which will have important implications for both the breadth and momentum of the USD rally from here,” he says.

Whether that lasts will likely be determined by the actions of Fed officials in the period ahead, he says.

“Given that we think the Fed will hike cautiously while much of the world is on hold, policy divergence for the USD will become much more one-sided and slow moving. This points to a less abrupt path for USD appreciation,” says Been.

If there is a risk to this view, he suggests it will be that inflationary pressures will intensify, something that few in markets anticipate.

“The key risk to this view would be that if inflation starts to look more entrenched than expected, then the Fed would be in danger of becoming too hawkish for the market.

“But for now inflation suggests a more stable path, and one that continues to favour the USD.”

Although Been is feeling more confident that renewed US dollar strength won’t prove as disruptive to markets as it was in the past, not everyone shares this view.

In a research note released earlier this week, Morgan Stanley’s emerging markets (EM) research team warned that the pillars that supported the rally in emerging markets earlier this year — a proxy for risk assets in general — were “crumbling”.

“The strong USD trend has resumed, and with Chinese data deteriorating and the Fed sounding more hawkish, two of the key pillars supporting the rally from February to April are now diminishing. Oil has been the odd one out, holding up relatively well, but if supply-side constraints fade, this would become a key risk factor,” wrote the bank.

Given recent events, along with signs that history could potentially repeat, the bank slapped an underweight rating on all emerging market asset classes that it covers.

“We are now bearish on all three sub-asset classes and expect negative total returns in USD over the next three months,” said Morgan’s.

“We move both local and hard currency sovereign debt to underweight from neutral, while remaining underweight EM currencies. We have also reduced the beta risk in our local currency portfolio by shifting away from some of the high-yielding opportunities to lower-beta bonds, while we maintain a very cautious country allocation in sovereign credit.”

With the Fed seemingly moving towards another hike near-term, and plenty of major economic data out in the coming weeks, including from China, it promises to be an interesting period for markets ahead.

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