Two Reasons Why the Dollar May Struggle for Direction

Summary

• As of 8 September, the dollar had risen by 4.8% since mid-July, its largest gain over a 41-day period since mid-October 2022. 
• However, the two historic USD drivers – Fed rate expectations and risk sentiment – are unlikely to steer the broad USD (either way) in the next few months. 

Dollar Winning Streak to Continue? 

The dollar (BBDXY) had an eight-week winning streak before last week, up nearly 5% since mid-July. Is this the beginning of a new trend? Macro Hive’s Richard Jones recently argued the rise has momentum to last into Q4 as US growth is outperforming, the USD is a high yielder, and rising oil prices are dollar positive. 

I sympathise with Richard’s arguments but am somewhat sceptical. In my base case, I expect the dollar to struggle for a clear direction this and most of next quarter. I find the two historic USD drivers – Fed rate expectations and risk sentiment – neither support nor oppose the currency. Therefore, I have argued idiosyncratic and relative-value (RV) trades are appealing, while carry should continue to perform. 

Historic Dollar Drivers Are Muted 

Since 2005, US rate expectations and global equities have explained nearly a third of USD quarterly variation. That is meaningful explanatory power given regressions are run on returns. Higher US rates are associated with dollar appreciation, and stronger equity performance with dollar depreciation (Table 1) – all very intuitive based on carry and flight into/out of safety. For example, spot USD tends to appreciate by 1.7% when US rates rise by 1ppt and weaken by 2.5% when global equities gain around 10%. 

Fed Rate Expectations 

I think the Fed has almost finished tightening monetary policy (the market is pricing 12bps of additional hikes). Yet there are risks of more (see below) – and changes in the dot plot released on Wednesday will trigger a market reaction. Inflation and wage growth are cooling as pandemic-era excess savings – in my view, the major culprit – are being depleted.  

Also, while the next market drivers will likely be the timing and magnitude of monetary policy easing, I believe the Fed will avoid explicit guidance on this. Memories of the ‘temporary inflation’ narrative in summer 2021 are still too fresh. Instead, I expect communication to maintain optionality. That should keep markets on the fence and rate expectations relatively stable – albeit with some volatility. 

Risk Sentiment 

Without rate expectations driving the broad dollar, I think risk (equities) become pivotal. Yet absent an exogenous shock, my base case is for range trading this and next quarter. This will leave the USD struggling for direction. 

1. On valuation, equities do not look expensive relative to bonds. Macro Hive’s Bilal Hafeez and Viresh Kanabar recently showed the implied equity risk premium (IERP) is around 5%, in line with its historic average. Implied ERP corrects for the asymmetric impact of inflation on equities and bonds, equity buybacks and variability in earnings growth expectations. In a nutshell, current relative valuations scream neither over- nor under-valuation. 

2. Absent another geopolitical or exogenous shock, global growth is unlikely to plummet or accelerate meaningfully over the next few months.  

On one hand, global activity trackers such as the composite PMIs reflect a clear slowdown but also a broad-based manufacturing rebound – albeit from very low levels – consistent with muted global growth for now. 

On the other hand, a material reacceleration of the global economy would need China at its epicentre. I think the last two years suggest Chinese authorities aim to (i) provide a backstop rather than an outright boost to the troubled property sector and (ii) improve quality rather than quantity of growth. 

In short, China is unlikely to under- or over-shoot GDP growth expectations meaningfully; nor will global activity. This is important because equity returns have a tight historical correlation with world growth (Chart 2). Therefore, the absence of material equity gains/losses into yearend will likely leave the dollar minimally impacted. 

Risks to My View 

I see three main risks to my narrative (barring exogenous shocks): 

1. US fiscal policy becoming even more expansionary, possibly slowing inflation’s return to target. This would imply (a) outright USD support from higher rates and (b) higher global recession probabilities (USD-positive) as the Fed will be seen tightening monetary policy aggressively and raising real rates materially above 2%. That would be negative for risk sentiment and carry trades in EM. 

2. Chinese authorities opting for enhanced growth-friendly support packages. That would mean global growth expectations are re-rated higher – akin to Q422. In that case, the dollar comes off. The main beneficiaries would be the commodity FX bloc as well as the euro via its trade linkages. Carry would be further underpinned.  

3. Oil prices continuing to rally (potentially higher than $120/barrel), squeezing consumer spending and precipitating a global recession and an equity bear market. 

Vasileios Gkionakis (Vas) has over 17 years of experience in research and portfolio management, both on the sell and buy side (Citigroup, BAML, UniCredit, Fulcrum Asset Management, Lombard Odier). He has held various roles including Co-Head of Strategy Research and Head of FX strategy. Vas holds a PhD from the London School of Economics.

Photo Credit: depositphotos.com

(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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