While sentiment has shifted, we expect a greenback comeback.
With the USD Index struggling to gain traction in recent months, rally attempts have sputtered, even though the dollar basket looks to be forming a bottom. However, while we have noted that Bridgewater Associates – the world’s largest hedge fund – supports our U.S. federal funds rate (FFR) conclusion and its implications for risk assets, the firm is bearish on the LONG-TERM outlook for the U.S. dollar.
For example, former Chief Investment Strategist Rebecca Patterson (who left the firm at the end of 2022) wrote on Jan. 18:
“The dollar is likely to decline further if we continue to see a combination of improving economic conditions in the rest of the world, and a scenario of ;immaculate U.S. disinflation’ that would allow the Federal Reserve to slow its pace of rate rises without unduly undermining growth (…).
But a word of caution (…). A rapidly, notably falling dollar would provide an unwelcome measure of support for U.S. inflation – making the Fed more inclined to keep policy tight, even if it means a deeper recession. We are in a world with an ample number of catalysts that could reignite global growth and stability fears or lead the U.S. to outperform again. For now, the dollar is down but not necessarily out.”
To that point, we’ve warned repeatedly that investors’ optimism loosens financial conditions and helps spur more inflation. So, when interest rates decline, the U.S. dollar weakens, stocks rise and credit spreads narrow, the re-pricings stimulate the U.S. economy and enhance the pricing pressures.
As such, Patterson correctly noted that a weaker USD Index provides “an unwelcome measure of support for U.S. inflation,” which makes the Fed’s job more difficult, and should have hawkish ramifications in the months ahead.
Likewise, the link in the opening paragraph outlines co-CIO Bob Prince’s thesis for why wage inflation should keep output inflation uplifted until a material decline in nominal spending and corporate revenues elicits a sharp rise in the U.S. unemployment rate. Although, he also commented on the overvaluation of the U.S. dollar. He wrote:
“Because the dollar acts as the world’s primary funding currency, tightening by the Fed has a large impact on other countries’ balance of payments. As that tightening drives up the dollar relative to other currencies, foreign dollar borrowers are compelled to trade ever more of their weakening currencies for dollars to service their debts, thereby driving the dollar up even further (…).
“The aggressive tightening by the Fed, which has supported the dollar squeeze, has also pushed the dollar to the high end of its long-term ranges and the current account into deep deficit…. As a result, the dollar is vulnerable to a weakening of the U.S. economy and a reversal of the tightening cycle in the U.S. relative to abroad.”
Please see below:
Source: Bridgewater Associates
To explain, the first chart at the top highlights how the Trade-Weighted USD Index has gone from near-record lows to near-record highs in ~13 years; and with mean reversion undefeated, a period of substantial weakness should confront the dollar in the years ahead.
Likewise, the second chart at the bottom showcases the U.S.’ current account deficit as a percentage of GDP. In a nutshell: when the U.S. imports more goods and services than it exports, it becomes a debtor country, which means more Treasury issuance, and potential weakness in the currency.
Again, though, these are long-term issues that the U.S. will have to deal with in the years ahead. Furthermore, the analysis aligns with our long-term thesis, as we believe the PMs will soar after they bottom later in 2023.
In contrast, the outlook for the U.S. dollar over the next several months is constructive, in our opinion, and even Bridgewater Associates acknowledges that a risk-off environment is bullish for the greenback. As such, with the S&P 500 likely far from its medium-term nadir, the next bout of fear should help re-ignite the USD Index’s bull market.
Please see below:
To explain, the green line above tracks the S&P 500, while the red and gray lines above track the inverted (down means up) USD Index and Cboe Volatility Index (VIX). If you analyze the relationships, you can see that when the VIX spikes, the USD Index often records substantial rallies (the red and gray lines falling).
In addition, sharp spikes in the VIX often occur when the S&P 500 sells off. Yet, with little fear confronting the financial markets right now, the VIX is near 20, and it rose slightly on Jan. 19.
Thus, if you focus your attention on the right side of the chart, you can see that the S&P 500 has pulled back (the green line falling), the VIX has risen slightly (the gray line falling), and the USD Index has declined (the red line rising).
As it stands, the absence of fear helps keep the USD Index down, but we expect that to change as the FFR continues its ascent. So, while the USD Index’s long-term outlook is bearish, its medium-term outlook is bullish because a VIX spike should occur before this bear market ends.
Please see below:
To explain, the red line above tracks the weekly movement of the USD Index, while the gray line above tracks the weekly movement of the VIX. As you can see, when the VIX rises, the USD Index is often a major beneficiary. Moreover, whether the USD Index is at high or low levels and panic strikes, the dollar basket often rallies hard, regardless of the starting position. So, while valuation matters over the long term, sentiment overpowers valuation when fear erupts.
Conversely, the right side of the chart shows how the USD Index and the VIX have both declined, with the latter at highly depressed levels relative to the fundamental risks that remain. Consequently, the VIX should have plenty of room to run, and its likely ascent should support the greenback over the medium term.
Overall, gold remains uplifted as the bearish medium-term catalysts have been ignored in the short term. But, with the Fed still materially hawkish and the fundamentals supporting higher interest rates, the pivot optimism priced in should reverse in the months ahead.
Where do you see the USD Index going? Is too much optimism priced into the euro? And how likely is a VIX spike before a Fed pivot finally arrives?
Alex Demolitor
Precious Metals Strategist