Aaron Costello
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
We are not ready to pronounce the strong dollar cycle dead, but do admit the US dollar is in critical condition. Investors should remain partially unhedged or prepared to ride out a period of currency volatility.
It’s been a cruel summer for the US dollar. The DXY currency index has given up all its gains since the November 8 US presidential election and then some. The dollar has been under pressure all year after surging in fourth quarter 2016, and the sell-off intensified over June and July, in part due to disappointment over the Trump administration’s ability to pass anything and excitement over the prospect of the European Central Bank (ECB) “tapering” its asset purchases.
Many analysts have declared the US dollar “dead,” and recent market action certainly indicates a sharp change in sentiment. However, we are not quite ready to throw in the towel for a few reasons:
• The market is overly focused on ECB tapering and ignoring US Federal Reserve balance sheet reduction. The former implies that the ECB will slow its rate of asset purchases, while the latter implies an actual contraction in the Fed’s balance sheet. Said differently, the net supply of euros is still set to expand, while the net supply of dollars should contract. This should be dollar supportive.
• The ECB and Bank of Japan are still far from hiking interest rates, while markets overly doubt the Fed. ECB President Mario Draghi has suggested that the central bank may start reducing its asset purchases, but has also repeatedly said he does not want to tighten financial conditions in the Eurozone. The Fed continues to state its intention to tighten policy. Yet, the markets now expect only one additional rate hike in 2018 and one in 2019. If the US economy is so sluggish that the Fed needs to sit on the sidelines for the next two years, that does not portend well for the global economy or stock markets, and makes it doubtful that the ECB will be hawkish, especially since a strong euro will weigh on Eurozone growth and inflation.
• The bar is now set low for the US dollar. Much of the run-up in the dollar was based on expectations of US fiscal stimulus. Clearly, all of that froth has been taken out, and deadlock in Washington seems priced in. Lackluster US growth has also weighed on the dollar (via expectations for Fed policy), but any regained momentum in the US economy could see the dollar snap back to life. Based on data from the US Commodity Futures Trading Commission, the market has gone from net long to net short US dollars. Meanwhile, the market is now net long the euro to an extent seen at previous euro peaks. Conditions are growing for a short squeeze.
• The US dollar typically rises amid market volatility and recessions. Historically, the Fed easing monetary policy during a recession is what triggers weak dollar cycles, but only after the dollar rises first amid a market “flight to safety.” If the US outlook is really as lackluster as is priced into the fixed income market, then market volatility should rise and equity markets reprice. Even though that may or may not send the dollar back to new highs, it should send the dollar higher temporarily.
The next Fed meeting on September 20 will be critical, as the Fed is widely expected to release the details of its balance sheet run-off plan and updated forecasts for the path of rate hikes. Any disappointment or clear dovish turn by the Fed may be the final blow for the dollar, at least until market volatility returns.
However, taking a step back, and as we discussed in March, whether the US dollar reaches new highs this cycle is less important than recognizing that it’s late in the cycle, and meaningful dollar weakness is likely over the coming decade, regardless of what happens over the next 12–18 months.
With it not exactly clear that we have entered a US dollar bear market (as there may be one last hurrah in store), investors should be partially unhedged versus the dollar or prepared to ride out the currency volatility. This can be done by overweighting non-USD assets or by reducing hedge ratios (or both).
Originally published on August 1, 2017
Aaron Costello is a Managing Director on Cambridge Associates’ Global Investment Research team.
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