Dollar Weakness To Help EM FX (3 min read)

It may be too soon to tell whether the dollar index breaking below its 200-day moving average will open the door for a long-term decline in the dollar. But, from a long-term perspective, it fits with the narrative that the USD is close to peaking. Indeed, we could even argue that the USD has been close to peaking for several years now, or at least since H2 2015 (see first chart). Since then, the broad dollar has essentially moved sideways despite the Fed being the only major central bank tightening, the bad news coming out of Europe, and the continued uncertainty over China’s growth outlook.

Chart 1: Assessing the Structural Trend of the US Dollar

Chart 1

Source: Macrobond, Bloomberg

The Dollar-Growth Link

The dollar failing to capitalise on the above might be because a sustained Fed hiking cycle is simply not compatible with a stable US inflation and growth dynamic, particularly if the rate increases also lead to a stronger dollar. Why? A weaker dollar is the most effective way to reflate the US economy and, by extension, the global one as well. This can be seen by how closely correlated the dollar is with both US manufacturing (e.g. the ISM survey) and inflation and how Emerging Market (EM) growth over time has moved in tandem with EM FX appreciation (see the second and third charts). In other words, a weaker dollar would help US exports, provide a floor for US inflation, and underpin EM growth.

Chart 2: USD Stabilisation May Provide a Floor in the ISM

Chart 2

Source: Macrobond, Bloomberg

Chart 3: EM FX Appreciation is Reflationary

Chart 3

Source: Macrobond, Bloomberg

Dovishness in Goldilocks Hurts Dollar

On a separate but related note, the June ISM report showed that output is holding up reasonably well, though it is currently at around 3-year lows, while prices paid continue to fall. If we look at the ratio of output-to-prices as an indicator of where we are on the “Goldilocks-to-Stagflation” spectrum, we remain much closer to Goldilocks territory (see fourth chart). Combining this with Fed Chairman Powell repeating his wish to “sustain the expansion” seven times at his June press conference, the subdued inflation backdrop means there is little to prevent precautionary Fed rate cuts should US data falter further. Looking back to the previous Fed rate cutting cycles in 1995, 2001 and 2007 respectively, the USD is vulnerable ahead of a potential rate cut at the end of July or mid-September (see fifth chart).

Chart 4: US ISM: Output Vs. Prices Components (standardised)

Chart 4

Source: Macrobond, Bloomberg

Chart 5: EUR/ USD in the Run-up to Fed Rate Cutting Cycles in 1995, 2001 and 2007 Respectively

Chart 5

Source: Macrobond, Bloomberg

Stars Aligning for Dollar Weakness

All in all, while it might be too early for a conclusive judgement, the pieces may be falling into place for more pronounced weakness in the dollar. We have verbal intervention against dollar strength by the Trump administration, growing twin deficit concerns, and a more dovish Fed (see the sixth and seventh charts). And all this at a time when investors are positioned for dollar strength, leaving scope for dollar longs to be unwound and result in dollar selling (see eighth chart).

Chart 6: US FX Policy Intervention Around Previous Dollar Peaks

Chart 6

Source: Macrobond, Bloomberg

Chart 7: Widening Deficits Threat to USD

Chart 7

Source: Macrobond, Bloomberg

Chart 8: Aggregated Net USD Position (CFTC)

Chart 8

Source: Macrobond, Bloomberg

Henrik Gullberg is a Macro Strategist and has previously pursued Macro Strategy roles at Nomura, Deutsche Bank and Calyon. He can be contacted here.

(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.)

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