Ok, I’m going to stay largely out of the “impossible trinity” debate re: higher stocks, rising bond yields, and a weaker dollar because i) nothing is “impossible” (I mean after all, make-believe space tokens were trading at $20,000 just over two months ago), and ii) there are factors at play here that are unprecedented in terms of both the disparate pace of stimulus unwind across advanced economies and lunatic U.S. fiscal policy that’s throwing a monkey wrench in everything. On top of that, there’s the whole issue of reserve diversification and that’s probably going to become an important longer-term story, especially if the administration continues to make economic enemies.
Deutsche Bank had a pretty succinct take on the dollar out last week which you’ve probably seen. Really, there wasn’t a whole lot to it and maybe that’s the beauty of it – elegance is often to be found in simplicity. If you missed it, DB attributes dollar weakness to the following two factors:
- US asset valuations are extremely stretched. Simply put, U.S. bond and equity prices cannot continue going up at the same time. This correlation breakdown is structurally bearish for the dollar because it inhibits sustained inflows into U.S. bond and equity markets.
- Irrespective of asset valuations the U.S. twin deficit (the sum of the current account and fiscal balance) is set to deteriorate dramatically in coming years.
So there’s that.
Well on Tuesday, the greenback is higher for a third day, which is notable considering that last week looked like it might mark the end of the nascent bounce off the Mnuchin-inspired lows.
For whatever it’s worth, Goldman is out with a “Q&A” on dollar weakness and it’s probably worth highlighting a few excerpts.
First, Goldman notes that there’s nothing particularly unusual about the dollar weakening as the Fed hikes. “Of the six tightening periods since 1980 (including the current one), half have been associated with Dollar strength and half with Dollar weakness,” the bank writes.
Additionally, Goldman notes that “the 2004-06 period demonstrates that we can observe this pattern even when Fed rate increases widen rate differentials between the US and other major markets, and when policymakers raise rates more than initially discounted.”
They go on to posit that other currencies are more levered to the synchronized upturn in global growth and, in a nod to what I mentioned here at the outset about the impact of stimulus unwind across disparate economies, Goldman says trends in global growth point towards policy convergence with the U.S.
If you’re ask them (which you implicitly are if you’re reading the note), they “expect a number of other countries to see higher policy rates this year (e.g., Australia, New Zealand, Sweden and Norway), and the ECB, while not expected to tighten for some time, has turned its attention away from easing and toward eventual normalization.”
Next, Goldman attempts to resolve the debate about the breakdown in the correlation between rate diffs and the dollar. Here is their three-point rationale (truncated in the interest of preserving your sanity):
- First, wider rate differentials are no longer resulting in fixed income demand from Europe and Japan to the same extent as in prior years. This could result from expectations of eventual monetary policy normalization in those markets, policy-related FX reserve diversification, or some type of home bias limit (e.g., a hedge ratio restriction) that prevents the USD share of assets from increasing further.
- Second, rate differentials may no longer serve as a good proxy for broader asset market returns. For example, with the acceleration in growth outside the US, investors may see better equity and FDI opportunities in other markets.
- Third, Dollar weakness may have some trade-related drivers (as opposed to capital flow-related) owing to strong demand for imports by US consumers (real imports of consumer goods were up 12%yoy through December)
There’s a ton more in the note, but those are the high points (or the “low” points in the context of the greenback).
All in all, Goldman is sticking with their forecast for a “soggy” dollar, owing in part to a discussion we highlighted previously which basically revolves around the extent to which some investors are still structurally long USD assets at what is perhaps the “wrong” time.
In any event, take all of that for whatever it’s worth, and if you don’t agree with it, don’t fret because invariably, this debate will rage on for months.