Bilal’s Macroscope: The Dollar End Game

First things first – I’ve changed the name of this note to ‘Bilal’s Macroscope’ from ‘Friday Reflections’. That was down to a team vote but let me know what you think. In case you’re wondering, a ‘macroscope’ is the opposite of a ‘microscope’ – that is, a way of looking at the big picture rather than zooming in to see the small details.

As for markets, this week does feel significant. The Federal Reserve (Fed) hiked past its 2015-2018 peak, while the Fed’s dot plot has the Fed’s terminal rate getting closer to the 5.25% peak of the 2000s hiking cycle, which we discussed last week. On top of that, we have seen Japanese FX intervention, the dollar making new highs against other currencies, stocks plunging and a huge UK fiscal package.

What’s Your Endgame Like?

The significance of the week could be that this is the beginning of the end game for the dollar. In chess, the endgame is the point of the game when lots of the major pieces have been removed and the stage is set for the king to be captured by either side. Importantly, while the players know the end is in sight, this part of the game can take time. It’s also the part of the game when the ‘less’ significant pieces, the pawns, become very important. The dollar is at this stage. And like in chess, this phase may take time and it could well be the things we tend to ignore (the pawns) that matter the most.

One reason for thinking that the dollar is the endgame is that dollar cycles tend to last around seven years. The current dollar uptrend is over ten years old. This makes the dollar strength very mature. The dollar has yet to reach the levels it got to in 1985 – but we are only 5% away.

What We Are Missing

As for what we could be missing, we have to remember that the 1980-1985 and 1995-2002 dollar uptrends both saw the final dollar surges occur with the Fed easing. That means for all our focus on the Fed cycle, this may not be the key to the dollar reversal. So, what could we be missing? Here are two ideas:

1. The US may soon want a weak dollar. The US trade balance is improving, which will likely add some percentage points to US growth. In a period, where growth is hard to come by, this may become an addictive new source of US growth.
   
   This would fit into the US goal to re-shore manufacturing, especially in the technology sector. Earlier this year, Intel announced plans to build a ‘megafab’ (chipmaking site) in Ohio. And a few weeks ago, the US banned the export of NVIDIA and AMD AI chips to China. NVIDIA stock is down 17% this month compared to Nasdaq, which is down 7%. An important part of a manufacturing renaissance would be a weak dollar. This would be similar to the backdrop to the Plaza Accord in 1985.
   
2. A turn in US bond inflows, especially credit. In the twelve months after the start of COVID, in 2020 – foreigners bought $400bn of US equities – the largest amount in US history. But, since then, foreigners have sold US equities every month except four – a cumulative $280bn of selling. Yet this has not stopped the dollar from rising.
   
   What has fuelled the dollar rally? Aside from flows chasing higher short-term rates, we have seen a surge of flows into US treasuries ($460bn) and US spread products, such as credit and agencies ($600bn). The flows into US spread products are the ones to watch as they tend to have lower currency hedges and so lead to net dollar buying. In fact, it was the flows into US credit that helped extend the dollar rally after the dot-com crash, in 2000, all the way to 2002. And it was the end of those flows that saw the dollar reversal. We, therefore, need to keep an eye on the credit cycle as that could be the cue for a turn in US capital flows.

For now, we like to be long dollar against the euro and north Asia FX. We stay on the sidelines on USD/JPY and GBP/USD for now. We are also starting to monitor the two factors mentioned above more closely to know when to get out of our core dollar longs.

Geeky Look at Long-Dated Forwards

In my last note, I banged on about how US yields will go higher than most people think. This thesis is playing out. Rather than belabouring that point, I thought it would be interesting to connect rates more explicitly to FX. We can do this by looking at longer-dated FX forwards.

Take USD/JPY – spot is currently trading around 143. This is only a few figures below the 1998 high of 147. This would suggest it is worth selling USD/JPY – at least on a medium-term basis. On top of that, our PPP models suggest fair-value for USD/JPY is 80, and even adjusting for terms-of-trade shocks, it is 110. So, again, these suggest the medium-term trade is to sell USD/JPY as it heads to these fair value levels.

But what are FX forwards pricing for USD/JPY? These forwards are calculated by taking the five-year swap yields for each country and then combining with spot to arrive at the forward price. Doing this for USD/JPY, we find five-year FX forwards to be around 113.

So, markets are already pricing a move back to the terms-of-trade adjusted fair value levels of 110 in the next five years. To make serious money, we would need to see USD/JPY fall well below this level. Put another way, we need to incorporate the fact that selling USD/JPY means you are negative carry, so you need outsized declines in USD/JPY to compensate for that.

Here are the five-year FX forwards for key FX rates (current spot in parenthesis):

• EUR/USD: 1.06 (0.98)
• USD/JPY: 113 (143)
• GBP/USD: 1.11 (1.11)
• USD/CHF: 0.86 (0.98)
• AUD/USD: 0.66 (0.66)
• USD/CAD: 1.30 (1.35)

When looked at in this way, for low-yielding currencies such as the euro, Swiss franc or yen, we need to have a punchy appreciation target for the mean reversion trade (selling dollar) trade to work.

Do Models Agree With Us?

I always like to cross-check our macro-based views with our models. Here is what they are telling us.

• Our momentum models find that for US rates, the models have worked best for long-dated bonds (30Y) – these models are giving a ‘sell’ signal. This goes against our curve flattener view. This makes me wonder whether we are being cute with our rates trade and should perhaps just have outright short rates trades. Elsewhere, all the FX models continue to give buy dollar signals, which supports our view. The models have not performed as well on equities.
• FX carry trades continue to perform well – all of these models are short EUR, CHF, and JPY. Over the past year, our carry:vol strategy is up 25%!
• Our positioning data finds both hedge funds and real money are bearish yen, pounds, and aussie. They disagree on the euro. On rates, hedge funds are bearish while real money are bullish. On equities, both are relatively bearish.
• Our ECB hawkometer finds most ECB members have become more hawkish which goes against our short euro view.

Oh, and if you want to sound smart on crypto, check out our piece on the ethereum merge.

Recent Questions from Clients

• What would lead to a new Plaza Accord? (answered above)
• Is UK an EM market?
• Will Russia use nukes?
• Can high US debt levels cope with higher rates?
• Why didn’t the Fed hike 100bps if they are so hawkish?
• What is the best market to be long in?
• Are private markets a bubble?
• Why did SEK weaken after the Riksbank surprise hike?

What I’m Reading and Watching

• With the ascension of Charles to the British throne as King Charles III, I looked at what happened the last time we had a King Charles… a British civil war.
• I’m interviewing the Head of Physics at Oxford University next week, so I’m brushing up on my quantum physics by reading How to Teach Quantum Physics to Your Dog.
• On a similar vein, I liked this article: Machine Learning’s ‘Amazing’ Ability to Predict Chaos.
• I thought this paper on the use of EBITDA add-backs to loosen financial covenants on syndicated was useful. It finds that these add-backs increase the risk of default.
• A new ECB paper on whether the green transition will be inflationary (they say in the short-term yes, but not in the long-term).
• I liked this article on the poor state of the web in terms of knowledge. E.g., ‘we have the ‘social web’ firmly in the hand of marketeers, bots and political propaganda….’
• This was cool: Every David Bowie Hairstyle From 1964 to 2014.
• New Gallup survey on well-being – they find ‘People who love their jobs do not hate Mondays.’ And ‘Volunteering is not just good for the people you are helping; it is also good for you’.

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.)