Dollar doldrums

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Good morning. For every up, there is a down. Yesterday’s Federal Reserve minutes show the central bank’s Open Market Committee considering the risk created by a better job market — namely a potentially “slower and more uneven than generally expected” path to the 2 per cent inflation target. The possibility of rate increases was discussed. Have markets been too optimistic in expecting significantly lower rates this year? Email us: unhedged@ft.com.

The dollar’s dolour

Headlines about the US dollar have been bearish lately. Many observers take the view that the greenback has been limp because the old, dollar-centred economic order is breaking down. Robin Brooks at the Brookings Institution suggests we are seeing a regime change, as illustrated, for example, by the currency’s non-reaction to the stronger than expected January jobs report last week:

The dollar was flat, which is pretty remarkable given the move [higher] in rates. Ever since 2014, positive data surprises have pushed the dollar higher, but this wasn’t always so. In the years after the 2008 crisis, the Fed used multiple QE programmes to cap Treasury yields. This caused markets to sell the dollar when data surprised positively because markets believed positive surprises — with the Fed acting in this way — pushed down real rates. With all the political pressure on the Fed, my view is that we’re going back to this negative correlation . . . whereby the Fed is seen as increasingly politicised, causing markets to sell the dollar on strong data.

We’re not buying this. The currency is performing exactly as we’d expect, given expectations for rates, the state of the US economy and global investors’ need to hedge against dollar volatility.

Traders have increasingly priced in three rate cuts by the Federal Reserve this year. As Elias Haddad at Brown Brothers Harriman points out, this makes sense of the greenback’s sideways grind since last June. Whether 75 basis points of rate cuts are realistic is debatable — we’d bet on less than three — but accepting the expectation, the dollar’s behaviour is logical. Short-term yield spreads between the US and other developed economies have narrowed significantly. Chart courtesy of Haddad:

Freya Beamish at TS Lombard argues the traditional dollar smile theory also provides a good explanation for these times. As a reminder, the dollar smile model says that when the US economy is significantly outperforming the rest of the world, the currency rises as capital flows into the country to join the party. When the US is underperforming, that is bad news for everyone, so investors buy the dollar as a haven, again pushing the greenback up. It is only in the middle, when the US is just OK, that the dollar weakens. Beamish thinks we are currently living in the belly of the smile, even as US growth is holding up nicely:

The [growth difference] with, say, Germany, is the smallest it has been in a very long time, like 15 years. So, in terms of a valuations perspective and a capital flows perspective, that’s more interesting to me. And that is before you start to bring in all the other sorts of structural changes that are happening in the US.

The “structural changes”, of course, are a polite way of referring to the macro fears from the Trump administration’s erratic geopolitical strategy and pressure on Fed independence, which undercut confidence in the US economy, despite strong growth. This rhymes with Brooks’ view, in that both see administration policy as weakening the dollar. But the difference is Brooks sees a change in correlation regimes, Beamish sees policy as a drag on economic confidence in the US.

We’ve never believed that there was a “Sell America” trade. Investment inflows to the US rose to record levels last year despite “liberation day” and all the rest. And the wholesale replacement of the dollar as the world’s reserve currency looks far-fetched, too. But investors are hedging their dollar exposures more, which also weakens the currency at the margin, as Beamish explains:

The dollar system is just now more prone to depreciation shocks because of the nature of the shocks [from the Trump administration] and because hedging ratios had fallen so much over the years when foreign investors were trying to find yield. They’re now in a position where, when they get a shock, they won’t necessarily respond immediately by selling the US asset outright or trying to reduce their allocation. They increase their hedging ratio, and then the dealer is left with a long dollar position, and they’re selling into a spot market where there’s no one on the other side.

It may not be for a lack of trying, but the Trump administration has not managed to change the dollar’s basic position in the world economy. US deficits and trade and investment balances remain skewed in the same way they have been for years. The dollar remains the indispensable currency. Regime change will have to wait until that changes.

One good read

LAD (love addiction disorder).

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