The Dollar Endgame Has Begun!
- By Bilal Hafeez
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- 3 min read
Summary
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- The current dollar uptrend has lasted three years longer than the average (seven).
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- Now, foreign investors are selling US equities while the market thinks the Fed is near the end of its hiking cycle.
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- We think the dollar is in its endgame and outline three reasons we might sell it.
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Summary
- The current dollar uptrend has lasted three years longer than the average (seven).
- Now, foreign investors are selling US equities while the market thinks the Fed is near the end of its hiking cycle.
- We think the dollar is in its endgame and outline three reasons we might sell it.
Market Implications
- We think the dollar could weaken by 5% or more.
- To capitalise on this scenario, we should sell the US dollar (USD) vs euro (EUR) and Japanese yen (JPY).
Enter the Endgame
We are at the dollar endgame. The current uptrend has lasted three years longer than the average (seven), and USD remains near its highest levels since the mid-1980s. Now, foreign investors are selling US equities while the markets believe the Federal Reserve (Fed) is close to ending its hiking cycle.
What is an ‘endgame’? 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.
You could have constructed the same bearish dollar view at various points last year, despite it not playing out until the fourth quarter. Moreover, previous multi-year dollar turning points proved choppy before turning down. Therefore, we err on the side of caution, tactically trading the dollar for now.
Three Reasons We Could Sell the Dollar Right Now
- US recession fears. The US yield curve has inverted and suggests a recession is likely in 2023. Recent weak Purchasing Managers’ Index (PMI) and falling working hours data support this narrative. The exact timing of a recession is hard to discern, especially with a still-strong labour market. But until broader activity data turns up, the recession narrative will likely persist. The dollar has previously tended to trade sideways or weaken into recessions. Stabilising Euro-area growth and the China re-opening could further help this weak dollar trend as well. This shifts the dynamics towards rest-of-the-world growth outpacing US growth.
- Other more hawkish G10 central banks versus the Fed. Aside from growth, inflation trends are diverging. US core Consumer Price Index (CPI) appears to have peaked, while core inflation in the Euro-area, Japan, and most of the G10 continues to increase. This could be the typical lag seen where the US leads to the euro inflation cycle, which suggests the European Central Bank (ECB) is nearer the middle of its hiking cycle than the end.
As for the Bank of Japan (BoJ), 10-year Japanese Government Bonds (JGB) yields are trading at the 0.5% upper bound of the Yield Curve Control (YCC) target. This might result in another YCC widening, which could support the yen. Meanwhile, the Fed is reducing the size of its hikes. - Technicals support selling the dollar. Our momentum models are signalling to sell the dollar against both the euro and the yen. Hedge funds are scaling back euro and yen shorts, while real money is holding on to euro longs and reducing yen shorts. These trends could continue, supporting a weak dollar phase.
The US may also want a weak dollar. The improving US trade balance will likely add some percentage points to US growth. In a period where growth is hard to come by, that new source of it could become addictive.
This would align with the US goal to re-shore manufacturing, especially in the technology sector. In early 2022, Intel announced plans to build a ‘megafab’ (chipmaking site) in Ohio. Moreover, last summer the US banned the export of NVIDIA and AMD AI chips to China. A weak dollar would be an important part of a US manufacturing renaissance.
Conclusion
Overall, we expect the dollar to weaken by 5% or more. To capitalise on this move, we should short the dollar against both the euro and the yen.
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.