The U.S. dollar has appreciated against every Group of 10 currency this year. It’s done even better on a longer-term basis, with the Bloomberg Dollar Spot Index rising as much as 16% since May 2021 -- a massive move for a developed-economy currency. Naturally, betting on gains in the greenback has acquired a huge following, even among retail investors, gaining a cult-like status almost equal to the self-described “apes” that cheerlead for meme stock AMC Entertainment Holdings Inc.
If you’ve spent any time on Twitter you might know that thousands of people have subscribed to the “Dollar Milkshake Theory” coined by Brent Johnson of wealth management firm Santiago Capital. The theory is that all fiat currencies are flawed, and ultimately doomed to obsolescence because they are rooted in debt and not backed by any absolute store of value. But the dollar is less flawed than the others, because it is the world’s primary reserve currency and most global transactions, especially in the commodities market, are conducted in dollars. When the Federal Reserve begins to withdraw liquidity from the system via quantitative tightening, it becomes a net seller of US Treasury securities, which serves to constrain the amount of dollars in circulation. At the same time, the demand for dollars is increasing among borrowers who need them to make interest payments on the vast amount of dollar-denominated debt. Hence, the value of the dollar will increase over time.
On the surface, the theory seems to be working. But in the world of foreign-exchange, where $6.6 trillion trades hands each day, it’s hard to definitively connect cause and effect. The dollar could be rallying for any number of reasons. You might find it counterintuitive that the dollar is rallying when everyone seems to be saying an economic recession in the US is imminent, if it’s not already in one. However, inflation rates are high and the Federal Reserve has been more aggressive than other major central banks in tightening monetary policy to combat inflation. That has made interest rates in the US much higher and more attractive than most anywhere else in the developed world, luring money to the dollar. So maybe dollar strength is simply a function of interest rate differentials, as is the case with most currency movements. Whatever, the reasons, Johnson and his milkshake theory adherents are pretty happy these days.
At this point, what would cause the dollar’s rally to end and for the currency to weaken? The first would be if Fed suddenly began to ease monetary policy, which would put dollars back into the financial system. Interestingly, the dollar has declined a bit in the last few trading sessions, perhaps in connection with speculation that the Fed may have to start reducing rates at some point next year due to a recession, or that the rally needed a break after the euro fell below parity to the dollar for the first time since 2002. It’s too soon to declare the trend in dollar strength over, but the recent weakness is noteworthy.
I analyze markets from the framework of sentiment, and I have been observing bullish sentiment on the dollar building steadily over the last year to the point where it’s now at an extreme level. Google the phrase “Dollar Milkshake Theory” and what pops up in the suggested searches box is “How do I invest in dollar milkshake theory?” The only thing missing is an Economist cover on the strong dollar, much like the one in December 2016 that featured a muscle-bound George Washington. The only problem for the dollar bulls is that the currency soon experienced a period of protracted weakness after that magazine cover.
Being long the dollar is the oddest trade to form a cult around. The only real way to express a long dollar thesis in the market is via the Invesco DB US Dollar Index Bullish Fund exchange-traded fund. It had risen as much as 14.2% from its low in mid-January through July 14. Speculative sentiment usually forms around things that are more, well, speculative, with the potential for a lot more gains, like Tesla Inc. or the ARK Innovation ETF.
Johnson and his adherents have a provocative worldview, one in which the strong dollar is a “wrecking ball” that destroys other currencies and related assets. This is the “macro doom” that I have written about, that the dollar will become progressively stronger, and the result will be a crash in stocks and other risky assets. A strong dollar view is essentially a pessimistic view. And the theory may be correct, but like all trades it can easily fall out of favor for a period of weeks, months or even years. That is what inevitably happens when sentiment gets extremely hot -- and it may be happening now.
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