“I don’t think…” then you shouldn’t talk, said the Hatter.”
― Lewis Carroll, Alice in Wonderland
Commentary & Analysis
Fundamentals are still smiling at the dollar
There is a simple framework we can use to help evaluate the likely intermediate-term trend of the US dollar, measured in months and quarters. It is referred to as the dollar smile. I first saw this concept in a research note written by Stephen Jen, when he was with Morgan Stanley many years ago. I do my best to keep it in mind as I trade Mr. Greenback, as at times it helps keep me out of the weeds. At the moment the dollar smile is indeed happy with the buck.
Three scenarios gleaned from the dollar smile:
1) Left side of the smile reflects an appreciating dollar as global risk comes back into the financial system. From our current perspective, we are thinking about a major “risk off” safe haven bid into the dollar resulting from a big drop in the stock market. Though such a risk bid can be short-lived, it can be a powerful initial driver sustained by relative fundamental factors over the intermediate term.
2) The middle of the smile reflects dollar depreciation against the major currencies as the US economy decelerates or muddles through soft spots, while relative economic growth and yield (central bank policy catchup) begin to improve among in both the developed and developing world economies; i.e. some global inflation.
3) The right side of the smile reflects an appreciation in the dollar on the back of strong US growth and rising yield differentials. This backdrop pulls in hot money and a greater share of foreign direct investments as the US economy grows faster than key country competitors and the Fed is expected to hike rates faster than other major central banks (CBs). This process naturally tends to be self-reinforcing.
Below is a chart showing the path of 2-year relative yield spread favoring the US dollar compared to the euro, pound, Australian dollar, and Canadian dollar. Yield spread keeps grinding in favor of the dollar.
Looking at this another way, in the chart below we have compared the US dollar Index to the 2-year yield spread for the United States – Eurozone (the euro represents about 57% weight of the US dollar index). A rising spread (red line) means the US yield is increasing relative to the Eurozone. And as you can see, this spread has blasted off in favor of the United starting back in October 2016. Yet, the US dollar index is now nine points lower. With Eurozone growth concerns back in play, it doesn’t seem we will see this yield gap narrow anytime soon. And if interest rates still matter, and we think they do, this spread reality seems dollar supportive to say the least.
There is legitimate background expectation of CB interest rate policy catchup with the US Fed. Granted, the Bank of Canada and Bank of England have signaled rates will be headed higher soon. Additionally, the recent Reserve Bank of Australia minutes from their last meeting suggest the bank will be hiking sooner than was expected. Two points here: 1) We do not expect any major CB to be as aggressive as the Fed over the next 12-18 months, and 2) if there is a major risk event, i.e. a major stock market correction and/or a markdown in global growth as a result of the ongoing US-China trade tensions, the relative impact will likely moderate expectations more quickly for BOC, BOE, and RBA than the Fed.
Keep in mind currencies at the core are considered free-floating instruments in the developed world, and most of the key emerging markets. Free-floating means the price driver for a currency is based on supply and demand. In a world where global capital flows freely across borders (China’s effectively closed capital account being the major exception) these fund flows into currencies can further be broken into two broad baskets: 1) hot money; and 2) *foreign direct investment (FDI).
*Foreign Direct Investment definition should also consider US corporate repatriation triggered in large part by the recent tax cuts in the United States.
So, if you consider these two baskets of flows, you can then better understand why higher relative interest rate yield and economic growth for a country are powerful determinants for its local currency. Hot money moves to the highest real yield, and FDI heads to the country with the best longer-term capital gains opportunity which is an economic growth decision.
Presently, the US dollar is the winner on both yield and growth; and that lead may acceleration, at least on a relative basis.
Fundamentals influence currency values and currency values in turn influence fundamentals in a continuous feedback loop; this is what often drives powerful self-reinforcing trends.
And we suspect the next powerful trend in the dollar is up—and we are targeting to 100 once what we suspect is a minor correction is over.