Dollar Dolor
It’s been a spectacular year for the US dollar. Using the popular broad dollar index, it managed to rise to its highest level since 2002 by the end of September. Since then, the greenback has endured a peak-to-trough fall of more than 9% and continues to trend downward. A look at the chart suggests that another great dollar rally is over. The question remains: Has Wall Street really seen the dollar’s top?
To many, the answer is likely yes. That the dollar had a record run can be attributed to three main factors: China’s (then) aggressive Covid-Zero policy, Europe’s confounding energy crisis, and the Federal Reserve’s determination to curb sky-high inflation. Between them, the presence of so many risks convinced investors around the globe to take shelter in the traditional haven of the dollar. Here’s George Saravelos, global head of foreign-exchange research at Deutsche Bank AG:
Those three risks marked a definitive peak in November, in turn allowing for a sizeable USD turn. The dollar’s previously huge risk premium now looks far less stretched, also accompanied by a shift in speculative positioning to neutral.
The graph below shows the dollar risk premium, which is Deutsche’s measure of how well a currency is performing compared to what would be expected from standard monetary drivers, such as differential in interest rates. After a couple of dramatic switchbacks since the beginning of the pandemic, it’s looking more and more normal. This year’s peak surpassed 2020’s Covid high, but it’s been downhill since. The next question is will the dollar continue to fall? The answer: probably not.
The broad outlook for the US has been the same for many months. Investors are expecting a recession to happen, inflation to cool, and the terminal fed funds rate to hover around 5% (equivalent market-derived forecasts for the eurozone suggest that the European Central Bank’s target rate will top out at about 2.8%). All these should have supported a reasonably strong dollar. But for Evercore’s Stan Shipley, the macroeconomic shift elsewhere in the world is what altered the narrative:
For the EU and UK, the summer runup in energy prices (primarily natural gas) made a deep recession by late 2022/early 2023 almost a certain outcome. But the flow of high-frequency economy releases since mid-September has generally been better than expected.
This, Shipley writes, would likely prompt the ECB and the Bank of England to raise their policy rates faster than expected — a significant shift from the summer narrative that the energy situation would force the region’s central banks to stay more lenient for longer. Added to that is recent news of China moving away from its long-held Covid-Zero approach as the nation eases a range of restrictions such as requiring infected people to quarantine in centralized camps. At the margin, that implies a further pickup in activity, and thus higher rates outside the US.
The Evercore economist gives four implications of a tumbling dollar:
- Increase in the dollar value of foreign earnings, which account for around 43% of aggregate S&P 500 EPS, and free cashflow.
- Association with weaker growth; outflow of capital from the US drags real and nominal economic growth.
- Boost for inflationary pressures, especially for commodities given that the lag between the two is roughly less than a year, as import prices rise.
- Tailwind from industries with large foreign exposures, combined with a headwind for those with significant overseas costs.
Still, Deutsche Bank’s Saravelos believes that the dollar will continue to act as the perfect hedge to a long bond/equity portfolio with “little pressure on the market’s dollar cash allocation to shift as it is fulfilling its intended purpose.” And indeed, the dollar this year has been an almost perfect mirror image of the horrors of a balanced stocks and bonds portfolio, rising as many asset allocators took losses:
A yield-curve steepening driven by real rates and a convincing low in equities would further support his view. “Both metrics have been important dollar bearish markers in the past,” he said. He shows that, historically, the trough for the stock market has tended to come almost exactly at the dollar’s peak. So if you’re comfortable that the bottom for equities is in, it follows that we’ve seen the top for the dollar:
The Fed’s much-anticipated pause or pivot toward lower rates would further erode the dollar’s position as a high-yielding currency, according to Saravelos:
Bringing it all together, we are left with a neutral dollar view as the turn of the year approaches, in line with an L-shaped inflection point in this year’s trends rather than V. With the FX market entering a much choppier phase, this leaves significantly greater scope for idiosyncratic FX moves.
As concerns about the impact of Fed policy on growth and corporate earnings run rampant, here’s how Mark Haefele, chief investment officer at UBS Global Wealth Management, thinks investors can trade:
We favor defensive sectors and value stocks within equities; income opportunities in higher-quality and investment grade bonds; “safe havens” like the US dollar and Swiss franc, and seeking uncorrelated returns through alternatives.
The sum of all fears is denominated in large part in dollars. There are still risks out there; Wednesday’s news of an attempted neo-Nazi putsch in Germany, in combination with the refusal by Russian President Vladimir Putin to rule out using nuclear weapons, made that all too apparent. But at present, investors seem confident that the sum-total of all they need to fear is declining. They might well be wrong, and there are many ways that perceived risk could start to rise again. But while investors continue to exhale with relief, we can expect the dollar to keep falling.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
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