The Dollar Downtrend Has Started

• We think a new dollar downtrend is emerging. The earlier uptrend that started in 2011 is running out of steam with dollar unable to make meaningful new highs in recent years.
• The market has already priced a Fed pivot to four hikes in 2022, and the dollar typically weakens at the start of Fed tightening cycles.
• US real yields are expected to remain at the bottom-end of G10 real yield league table and EMFX still offers attractive carry vs USD.
• The US current account deficit has worsened and is reaching dollar reversal levels at a time when the US capital flow picture is worsening.
• USD/JPY could see a meaningful move lower possibly to 100, while EUR/USD could reach 1.25. Growth currencies such as AUD and CAD and EMFX could also strengthen against the dollar.

Understanding the Dollar Cycle

The dollar follows long-term cycles. Typically, it trends up for seven years and it trends down for seven years (Chart 1). Of course, the exact duration is not precise, but with a focus on the short-term, investors can easily miss the underlying trend. The latest dollar uptrend which started in 2011 started to run out of steam at the end of 2016. Since then, the dollar has been trading in broad range and moderate new high seen in early 2020 around COVID. This suggests the dollar uptrend is at the mature phase and we could be in the midst of a more meaningful turn down on the dollar.

Looking at dollar valuations against the majors, we find the dollar is around 10% overvalued against the euro on a PPP basis. While this is overvaluation, the euro never reached the typical 20% overvaluation (Chart 2). A reversion to fair value would suggest a move to 1.23.

Meanwhile, the dollar is overvalued by 40% against the yen. The last time we saw a similar overvaluation was back in the mid-1980s (Chart 3). Admittedly, Japan has recently experienced a sizeable negative terms-of-trade shock Japan with the surge in oil prices. This could justify the overvaluation, but it is still worrying sign for USD/JPY. Fair value on a PPP basis is 83 and move back to a 20% overvaluation suggests a move to 100.

What About the Fed Hiking Rates?

But perhaps the biggest in support of the dollar are interest rates. The Fed is expected hike rates four times and reduce the size of its balance sheet this year. In theory this should support the dollar, however markets are forward-looking and so the question is whether last year’s dollar rally already factored in higher policy rates.

On way to look at this is to see how the dollar has fared around previous hiking cycles. We find that since the late 1970s, the dollar has stumbled after the first hike and in some cases like the late 1980s and the 2000s the dollar downtrend continued for a number of years, despite the Fed hiking rates (Chart 4). This suggests there is an element of ‘buy the rumour, sell the fact’ where the dollar benefits before the first hike, but sells off after.

We could see this more clearly if we look at the average path of the dollar around the start of hiking cycles for individual currency pairs. For USD/JPY, we find that it tends to be stable in the six months leading up to the first hike, but falls by an average 10% after the hike (Chart 5). With USD/JPY trading around 115, this implies a move to around 105. The dynamic did repeat itself during the last hiking cycle in 2015 as well.

As for other currencies, we find similar effects but in smaller size. The dollar tends to rise against the euro into the first hike, but falls after – typically by around 5%. We see a similar patten against the Australian dollar (Chart 6). As for EM FX, we construct an equally weighted EM basket consisting of BRL, MXN, ZAR, TRY, INR and KRW. Over all previous hiking cycles, the dollar tends to fall by 10% against EM after the first hike (Chart 7). However, the reversal was less clear in 2015.

Overall, there is clear evidence that the dollar tends to weaken at the start of hiking cycle against most currencies.

Do Rate Spreads Matter?

Comparing US yields to other countries’ yields, for all the focus on rate spreads, the historic relationship between short-term (eg 2y) rate differentials and the dollar is mixed. In the most recent period, US rate spreads moved meaningfully in favour of the dollar from 2017 but the dollar struggled against the euro from that period onwards (Chart 9). Before that we find more stark divergences such in the early 2000s when the dollar was falling and US rate spreads were moving up. If we translate everything into real terms, we find that US real rate spreads had a clear relationship with the dollar in the late 1970s to mid-1980s but the relationship has been more mixed since (Chart 10).

As for USD/JPY, we find a similar ambiguous relationship as with USD/EUR (Chart 11). Given Japan’s low yields and low inflation, looking at everything in real terms makes more sense. Here we find more phases where real rate spreads move with USD/JPY – notably the late 1970s to mid-1980s and from 2002 to 2015. But recently we are seeing the largest divergence in history – that is USD/JPY is much higher than it should be compared to real rate spreads (Chart 12).

Who Offers Attractive FX Carry?

Rather than trends or change in yields, we can also look at the levels of US yields compared to other countries . To capture expectations we look at forward 2y yields – so a proxy of what yields are expected to be by the end of 2022 – that is, after a phase of hiking by central banks. We also look at real yields so we subtract these nominal yields by forecasted inflation.

We find that short-term nominal (2y) US yields are expected to be in the middle of the pack by the end of 2022 (Chart 13). NZD, CAD, NOK and AUD are expected to have higher yields. Meanwhile, the picture gets worse when we look at expected real yields. The USD tumbles to near the bottom of the real yield league table. Only GBP and EUR are expected to have lower real yields. Making matters worse, both the CHF and JPY are expected to have higher real yields.

Looking at current FX carry adjusted for volatility, we find that the majority of global (G10+EM) currencies have higher carry:vol than the dollar. INR, PHP, TRY, BRL and MXN have the highest carry:vol ratios (Chart 14). TWD has the worst, while most others like EUR and JPY are in a -/+ 0.2 range, which means the USD does not offer attractive carry. And even with four hikes by the Fed, the USD would not be able to catch up to the carry offered by the EM high-yielders.

Balance of payments Picture Worsening

Outside of interest rates, balance of payments dynamics have started to turn against the dollar. In the past, large deteriorations in the US current account balance eventually saw the dollar tumble. In the 1980s, once the current account deficit reached 2.5% of GDP, the dollar downtrend started (Chart 15). And then in the early 2000s, once the current deficit reached 3.5% of GDP, the dollar downtrend started.

Since the global financial crisis of 2008, the US current account balance has been improving – first it was helped by weak US demand and so lower imports and then the shale gas revolution which improved the US energy trade balance. But since 2018, the US current account balance has started to worsen. Last year, the deficit accelerated as the US embarked the largest goods consumption binge in its history helped by a massive fiscal stimulus. This saw imports pick up as much faster than exports. Worryingly, the current account deficit has now reached 3.5% – the threshold of the early 2000s that saw the start of the dollar downtrend.

Apart from looking at historic current account threshold to determine dollar reversals, we look at whether capital flows can support a growing current deficit without an FX adjustment. The picture on this front does not look promising.

Starting with US investor flows, we find that US investors have been aggressive sellers of their foreign equity and bond positions since 2015 (Chart 16). In fact, it has been the largest unwind in history. But we have started to see tentative signs that we may have seen peak selling. On top of this, last year US investors piled into US equity ETFs at a pace close to historical extremes (Chart 17). We could therefore easily see US investors start to rotate to international equities to diversify their exposure. This in turn would lead to dollar selling.

On the other side of the financial accounts, we find that foreigners continue to buy US spread products (credit and agencies) – this is dollar supportive, so is worth monitoring closely for a turn (Chart 18). Meanwhile, foreigners did buy significant amounts of US equities, but they have started to scale back, which is dollar negative (Chart 19).

Overall, the capital flow picture is turning dollar negative at a time the US current account deficit is entering dollar reversal territory.

Bottom Line

We think a new dollar downtrend is emerging. The earlier uptrend that started in 2011 is running out of steam with dollar unable to make meaningful new highs in recent years. More importantly, the market has already priced a Fed pivot to four hikes in 2022, and the dollar typically weakens at the start of Fed tightening cycles. On top of that, US real yields are expected to remain at the bottom-end of G10 real yield league table. Finally, the US current account deficit has worsened and is reaching dollar reversal levels at a time when the US capital flow picture is worsening.

USD/JPY could see a meaningful move lower possibly to 100, while EUR/USD could reach 1.25. Growth currencies such as AUD and CAD and EMFX could also strengthen against the dollar.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)