The Dollar Will Weaken, But Not Yet
Summary & Key Takeaways
Over the long-term, the fundamentals of the dollar suggest a downward bias is likely.
Likewise, sentiment and positioning remain elevated to levels indicative of long-term tops.
However, over the short to medium-term, the growth cycle outlook and technical picture are supportive of continued dollar strength.
It is still too soon to call the next bear market for the greenback.
Fundamentals - short-term tailwinds facing long-term headwinds
2022 saw phenomenal strength in the US dollar, the kind of strength that has a habit of hindering international trade, commerce and growth in a classic self-reflexive cycle. Being one of the most important variables to global asset allocation, having an opinion as to where the dollar is headed over the short and medium-term affords investors a significant advantage and should be an integral part of one’s investing framework.
For now, the outlook for the dollar appears somewhat mixed. Fundamentally, the outlook is probably best described as the clashing of short-term tailwinds in the face of medium to long-term headwinds. For currencies, fundamentals largely consist of factor such as fiscal and trade balances, as well as valuation measures based around purchasing power parity. Indeed, on most currency valuation models the dollar appears overvalued, as we can see below.
Source: Mark Investments
While this has little to no bearing on short or even medium-term movements, it is likely to influence the broad directional trajectory of the dollar over the next few years. This works in a similar manner to how valuations drive long-term stock returns, and is illustrated brilliantly in the below chart from BCA Research.
Source: Peter Berenzin - BCA Research
From a twin deficit perspective, the long-term move in the dollar appears to be lower. Consistent currency account deficits and budget deficits are generally associated with a lower currency, though this is of course not always the case with the dollar given its global currency reserve status. Longer-term however, trade and budget deficits do generally imply an overvalued currency.
Based on these long-term fundamentals, a weaker dollar is the probability an appropriate bias for investors to hold over the next few years. Unfortunately, dollar fundamentals matter much less in a world where the dollar is the global reserve currency. That is still very much the case today and will continue to be the case for the foreseeable future.
For the dollar, short to medium-term movements are influenced far more by things like the business cycle, which drives speculative flows based on things like positioning, interest rate differentials and relative economic and market performance. These factors tend to result in dollar strength during times of economic weakness.
So long as the dollar is the global currency, slowing growth should support the USD
The US dollar is the bedrock of the world’s financial system, as its use lies in the center of global trade and commerce. Given the amount of transactions denominated in US dollars, along with the amount of dollar denominated debt held by non-US entities, the availability and cost of dollars are paramount to the funding and economic viability of so many of the worlds economies. A lack of availability is dollars does not bode well for global growth, nor does slowing global growth bode well for the availability of dollars.
Many countries are reliant on the US to supply them with a sufficient number of dollars to facilitate international trade as well as finance their dollar debts in a cost-effective manner. This dynamic is why we see the rate-of-change in the dollar closely track the level of global exports and global trade. More exports equal greater worldwide dollar flows, reducing economic stress and vulnerabilities. When global trade slows, it becomes harder for the foreign sector to obtain sufficient dollars to settle trade and pay their debts, and generally causes the dollar to squeeze higher in a self-reflexive manner. This has certainly been the case during 2022, with many countries being forced to sell some of their US dollar assets (i.e. Treasuries) in order to obtain dollars, helping to push US yields higher.
As we can see below, the dollar tends to be negatively correlated with global trade, and global trade tends to follow the business cycle.
As the business cycle continues to deteriorate as we enter 2023, global trade will likely follow suit and with it the dollar is likely to remain bid.
While this does not necessarily mean the dollar must go higher, it does imply that it will be difficult to see a sustained move lower until we see a pick-up in global growth, or worse, until we see dollar funding pressures deteriorate in periphery countries with significant dollar debts and insufficient dollar-based reserves (Argentina, Turkey and Chile for example) and the Federal Reserve is required to step in. We are not there yet however.
So long as the Fed is undertaking QT, the foreign sector continues to no longer be buying US Treasuries on-net while the Treasury itself continues its own debt issuance, we are likely to have a supply and demand imbalance that should support a strong dollar.
As we can see below, an appreciating dollar tends to coincide with foreigners no longer funding Treasury issuance. And, when the Fed is also no longer monetising Treasury issuance, this responsibility falls to the domestic private sector, creating dollar scarcity until such a time as the Federal Reserve are once again required to step in. Unlike the Fed, the private sector does not have unlimited balance sheet capacity.
We are not yet near any kind of breaking point, and the decade-plus high in yields on offer from such risk-free securities is absolutely increasing the attractiveness of US Treasuries, but so long as the Fed is undertaking QT, this will likely support a stronger dollar.
Sentiment and positioning suggest the dollar is in the process of topping
If we turn our attention now toward the sentiment and positioning aspects of the dollar, the picture seemingly confirms that of the long-term fundamentals.
Looking at speculative positioning through the lens of hedge fund exposure and large speculators within the futures market, the former are still slightly long dollars, while the latter are still significantly net-long. We can see below how both have recently reduced their long dollar trades - which has largely driven this pull-back in the dollar - and how much potential there is for a further unwind in speculative positioning over the coming years should the dollar does eventually roll over. Speculators have a habit of being long at the tops and short at the bottoms, given the trend-following nature of their trades. For now, speculative positioning is still largely bullish.
Additionally, sentiment remains elevated to an extreme degree, per SentimenTrader’s Optix index. In fact, sentiment towards the dollar has only ever been this optimistic in 2015, of which the dollar struggled to make any major gains for years afterward.
This extreme optimism is perhaps best illustrated when looking at the ever reliable ‘magazine cover’ sentiment indicator, an occurrence summarised perfectly by Jesse Felder of the Felder Report:
“Recently, we saw not only one but two magazine cover indicators trigger for the dollar. First, it was BusinessWeek proclaiming it “unstoppable” with an image of a dollar sign blasting through a variety of other currency symbols. Then Barron’s followed up with it’s own cover story on the “superstrong” dollar featuring a musclebound George Washington.
Normally, one cover story like this would be a loud enough signal, pointing to the fact that bullish sentiment had reached an extreme, but the two together are nearly deafening. And if the trend in the dollar is poised to reverse, then it has important implications for asset prices, inflation and the economy.”
Source: Jesse Felder - The Felder Report
Such extreme levels of bullish sentiment tend to mark long-term turning points for most asset classes.
Technical picture suggests short-term strength
Shorter-term, it is the technical picture likely to provide the most clarity to where the dollar is headed.
On the weekly chart, the price action has been fairly textbook. The September peak in the dollar index occurred on the back of a completed weekly 9-13-9 DeMark sequential sell signal, which preceded a quick 10% drop to the 104 support level and the 50-week moving average. Given this pullback has occurred in such a swift manner and itself has triggered a DeMark sequential setup buy signal, this appears an excellent level for the dollar to stage another rally, or at the very least consolidate.
The daily chart appears to be confirming this view. We have just broken out of a bullish descending wedge pattern, in which the lows were accompanied by positive momentum divergences.
Unless this turns out to be a head-fake and the 103-104 level is lost to the downside, I suspect the dollar index will at the very least rally to test the 200-day moving average in the coming weeks to months. Dollar seasonality seems to be confirming this thesis, as the first two months of the year tend to be the most bullish for the dollar.
However, it is important to remember technical damage has been done in recent months, as was the viscousness of the sell-off from the September high. As we can see below per the work of SentimenTrader, whenever the dollar index falls by more than 4% in a single week, this generally indicates a long-term trend change and suggests price is headed lower over the next six to 12 months.
Does this mean the dollar has peaked on a cyclical basis? Perhaps. But if it is yet to peak, or at least remains elevated for the next few months (particularly if we do indeed enter recession in 2023), then we are likely to have yet to see the bottom in the stock market, as the two tend to coincide during recessionary periods.
Source: Deutsche Bank, Bloomberg
Implications of short-term dollar strength, and long-term dollar weakness
Whether or not the peak in the dollar and the trough in equities do coincide is only one of the many implications the dollars movement has on the asset class universe. There are a multitude of implications all investors should be aware of and consider as part of their asset allocation process if we do see continued dollar strength in 2023 following by dollar weakness in the years ahead. I have detailed these many dynamics in the past (which you can enjoy here), but simply, the dollar matters a lot for a multitude of asset classes and stock market sectors.
The below chart from Pictet Asset Management does a solid job of illustrating the how areas of the stock market tend to perform based on movements in the dollar. Primarily, when the dollar is strong, pro-cyclical equity sectors such as metals and mining, energy, commodities and materials, consumer discretionary, emerging markets, foreign equities and such are likely to struggle.
If we look at the recent correlations of stocks, commodities and gold to the dollar, dollar strength over the next few months is likely to be concerning for gold in particular, whose correlation to the dollar has been negative one for some months now.
Investors should be aware of how exposed their portfolios are to adverse movements in the dollar from both a cyclical and structural perspective. Should we see a rebound in the dollar in the months ahead, this is likely to be a headwind for cyclical and pro-growth assets, while a long-term dollar bear market should be supportive of such things as commodities, gold and emerging markets.
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