The Big Conversation
Episode 101: Will the dollar surge damage markets?
This week we look at the recent rally in the dollar, what’s behind it and whether it’s getting to levels that start to hurt risk assets. Emerging Market equity, one of the consensus trades for 2021, has failed to perform this year. Will the pain spread out to other assets or has the move in the dollar now run its course?
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Roger [00:00:00] The US dollar index continues to move higher, having gained nearly eight percent since the middle of the year, and also breaking through the key 50 percent retracement level of last year's range. The US dollar sits at the apex of the financial system. A rapid rise can have negative impacts on risk assets. So what's the outlook for the dollar today? Well, that's The Big Conversation.
Roger [00:00:24] During the early part of 2021, the broad based consensus was for US dollar weakness. The fact that this was a near unanimous view was actually a warning for investors. At the end of 2020, we highlighted that after a strong performance in H2, the long emerging market equity trade effectively a short dollar trade, was also one of the biggest consensus trades for 2021 in the Bank of America Survey of Investors. At the same time, we outlined the change in China's growth model. EM equities have struggled to perform this year. The much vaunted reflation trade never took hold in 2021 because we never saw the sort of globally coordinated growth that had previously put the dollar on the back foot when those higher beta emerging market currencies were leading the charge. Now, of course, part of the problem when commenting on the dollar today is that most commentaries fall into one of two aggressively tribal camps, either that of a dollar collapse, or that of a dollar surge. Most of the time, however, the moves are far more mundane, but that's not the sort of narrative that people like to hear. So coming back to the early 2021 narrative, the belief in dollar weakness largely stemmed from an expected divergence of policy. The US was combining a huge fiscal stimulus with massive monetary easing, and this was supposed to undermine the dollar. In fact, the tribal view was that the massive twin deficits would lead to the destruction of the dollar. Though that argument ignores the reality that most other regions are also struggling with their own growth. In the end, however, that expected relationship between expanding balance sheets and a declining dollar, well it failed to materialise. Probably because the rebound in global growth was very lopsided, with demand side policies in the US at least creating the sense that there was some consumer led growth. But as we've noticed on previous occasions, the main drivers of dollar weakness and strength in 2021 have come from a relatively narrow range of currencies. The broad based J.P. Morgan Emerging Market Currency Index, for instance, only partially engaged in the bout of dollar weakness last year. It's severely lagged other major currency indexes, such as the dollar index, and now the index looks set to break the lows. Most of the activity, therefore, has been driven by the euro. The euro accounts for just under 60 percent of the dollar index, so it's no surprise that the euro and the DXY are effectively a mirror image. And during this period, the relationship between central bank balance sheets ended up working in reverse. When the ECB was expanding its balance sheet at a more aggressive pace than the Fed, the euro tended to rally and vice versa. And the mirror image is pretty clear. When we invert the year, it's fair to say that the recent rise in the dollar has outperformed even during this recent period, where the Fed's balance sheet has expanded faster than the ECBs. The US has talked a good taper story, but it's not actually commenced any meaningful tightening. And another favourite story that failed to materialise was the collapse in US real rates, which was also supposed to undermine the dollar. U.S. real rates have collapsed, but they have been matched by many global peers, such as real rates in Germany. There's been no relative advantage or disadvantage, so the higher good prices in the US at least reflected increased demand, whilst higher input prices in Europe reflect higher energy costs. And for Europe, higher energy costs are an issue. They've been a drag on demand, and uncertainty remains because the Nordstream 2 pipeline continues to face regulatory scrutiny as well as geopolitical tensions. Europe is not self-sufficient in energy, and that's a problem when higher prices reflect supply constraints rather than robust demand. This has all been about price and not volumes. And Europe's also been impacted by that policy shift in China, which has bubbled through to depressed demand across much of the emerging market complex. Europe's heavy industry has become reliant on growth in developing markets, and that growth is not really being forthcoming. As a result, the relative economic surprise in the eurozone relative to the US has recently been struggling, and that appears to be weighing on the strength of the euro. But once again, we can see an acceleration in the currency move relative to economic differentials. Many of these trends were already well-established before the recent COVID surge in Europe, and eurozone policymakers are partly to blame. They indicated that they wanted a cap on the euro earlier in the year, and they appeared to have got what they wanted. When the real effective exchange rate of the euro has historically experienced a surge, eurozone policymakers have initiated a verbal intervention, and this chart, which we showed earlier in the year, suggests that verbal intervention once again coincided with a turning point for the euro. And another clue to potential dollar strength from earlier in the year was the lack of outperformance from emerging market equities. Even when the US dollar was on the back foot. The EM underperformance since then suggests there's more work than just a currency impact. The ratio of emerging market equities versus the S&P is close to the 20-year highs in terms of U.S. outperformance. And that's also helping the dollar because it's encouraging capital to continue chasing into those U.S. equity markets. And even when the US tech sector is taking a breather, its leadership is simply replaced by another US sector, such as small caps. Now, obviously, some of this EM equity underperformance was due to regulatory changes in China that saw extreme divergence from the US equivalents. We may now have seen peak regulatory change that favours a rebound in some of these Chinese tech names, though there remains a significant amount of uncertainty within China's property sector, which is a larger component of that economy than tech. So that's the backdrop of dollar drivers, which helps frame what might happen next. EM equities still look like an unexciting prospect. China may have implemented the main policy changes already, but they aren't suddenly going to jump back into growth policies that benefited the broad EM space before 2018. If anything, the current competition for energy supplies will continue to be a drag on EM growth unless the winter across the northern hemisphere is unusually warm. But could a stronger dollar help alleviate some of these energy price issues? Well, it's true that historically one of the classic outcomes of a stronger dollar is that it's a drag on those commodity prices. But so far, commodity prices have held up despite that dollar strength. There is a decent long term relationship between the two, but there are periods where they dislocate for a reasonable amount of time. In fact, the last few years have seen repeated divergences between the dollar and commodity prices. And one of the primary reasons why dislocations could persist today is that ongoing supply-side constraints across commodity markets. A hiher dollar impacts demand and therefore, if it was excess demand that was causing commodity prices to soar, then we should expect a reaction from a move higher in the dollar. But if it is supply side issues that are pushing prices higher, then there's not much that the level of the dollar or the threat of monetary policy can do about it. The supply issues will just need to work themselves through the system. But in terms of the dollar performance from here, the outlook is relatively sanguine. I'm in neither the tribal bull or the tribal bear camp. The fact is that with the DXY at ninety five and a half, it's marginally above the average level of the range that it's carved out since the beginning of 2014. Furthermore, with this improved performance, we've understandably seen a shift in the positioning and sentiment from earlier this year. The chart we featured in the summer was the performance of the euro versus the CFTC non-commercial, speculative positioning in the futures market, which we use as a proxy for overall positioning, even though volumes are tiny when compared to the over-the-counter markets. When we last showed this, the record longs, and these are not adjusted for open interest, so there's a bit of a fudge here. But the longs had already started to reverse. We pointed out at the time that once this started to reverse, it usually continued to move back towards a neutral position. And on every previous occasion, the euro has experienced a reasonably large drawdown. And that's again occurred this time. Safety positioning is now back at neutral, and it's dropped a very long way from the highs. Positioning is therefore far less of a factor today. We've also seen the dollar have a reasonably major turning point through four the last six year ends. Now, whilst that may see a little more than a coin toss, the point here is that the term did come around the year-end and often never looked back for an extended period after that. And one mantra that we've preached all year, however, is that it's not the level of the dollar that matters, but the size and the speed of the move. In many respects, the dollar has surged by recent standards, but it's nothing unusual on a longer-term view. Compare today's move with 2014, which was the last time we saw a major impact on global growth. That dollar rally led to a global industrial and commodities profits recession. Recently, we have started to see FX volatility rise off very low levels, suggesting that the move is not without risk. But we could argue, however, that given the size of the moves in the underlying currencies, the moves in volatility remain relatively subdued. One of the protection strategies that institutions have utilised, is surge protection against the dollar, especially when buying option hedges in the equity market, is still very expensive. Investors who've hedged their portfolios with long dollar calls have often been rewarded doubly, because the equity market has continued to rally as well. Today, though, not only has investor sentiment started to shift in favour of the dollar, but strategists are also starting to jump into the bullish dollar camp. This is no longer a one sided bet like it was earlier in the year. And the main thinking today is that we're seeing extreme policy divergence between countries with growth and inflation, which are taking off, versus those where growth remains subdued, even though inflation has picked up in many of those countries as well. Generally, the expectation is that the dollar should outperform versus low yielding currencies such as the Japanese yen, the Swiss franc and the euro. On the other side of the ledger, there's an expectation that commodity currencies should perform well against the dollar because of the stickiness in raw material prices, though, the Aussie dollar is dangerously close to key support. Maybe the worst of the supply chain issues are now behind us, and for developed economies that might be forced into early rate hikes, tighter policy should see their currencies outperform. But for emerging markets that are forced into rate hikes, well, that can often be a negative for currency performance. Our poster child in this category has been the Turkish lira, which had a single day decline in excess of 10 percent again this week. The dollar is getting overbought, but the risks of a disorderly surge in the dollar, one that aggressively tightens global financial conditions remains in play. The Turkish lira may not be a one-off, and whilst the dollar has already rallied, many of the biggest shock moves in any asset prices are often an extension of either an overbought or an oversold position. Now, that's not a base case. The dollar has merely ground into the middle of the range, but the risk of a surging dollar is one that prudent investors should consider hedging as an alternative to buying that expensive equity index put protection. It may be that both long dollar and long US equities can continue to climb into the end of the year because they may well be exactly the same trade. If you've got any questions about this episode, the economy or financial markets, please put them in the comments section or send them to TBC at Refinitiv dot com.