Goldman Asks: What’s So Special About The Dollar, Anyway?

By now, the previously “contrarian” view that beaten down ex-U.S. assets are set to “converge” with U.S. stocks has morphed into a consensus trade or, if it’s not quite a consensus “trade”, it’s certainly a narrative that’s on the tip of market participants’ tongues.

Whispers of a convergence between U.S. stocks and the rest of the world began last month and over the past couple of sessions, those whispers morphed into a veritable cacophony as EM equities put up their best week of the year versus the S&P.

In currency land, this was a blockbuster week for the Argentine peso and the South African rand, two of the poster children for EM FX malaise. When it was all said and done, MSCI’s gauge of developing economy currencies had its best week since January.

Behind it all: Dollar weakness. The greenback took a decisive turn lower on Thursday, helping to bolster risk sentiment and underscoring the notion that key to a benign resolution of the divergence between U.S. stocks and risk assets outside of the U.S. is a pullback in the dollar.

(Bloomberg) 

Dollar weakness in turn helped bolster downtrodden commodities, which rallied hard, perhaps tipping the return of the international reflation story, a meme that likely garnered further support from Chinese Premier Li Keqiang’s implicit and explicit stimulus promises.

(Bloomberg)

In light of the critical role the dollar will play in either deep-sixing the benign convergence story and/or renewed optimism around the global reflation meme (in the event of renewed USD strength), or else catalyzing further momentum in ex-U.S. assets and reinforcing the return of the reflation story (in the event of more dollar weakness), and ahead of the Fed meeting which will help determine where the dollar goes from here, it’s worth highlighting a few passages and charts from a Goldman note out Friday called “What Makes The Dollar Special”.

Goldman zooms in on what the bank describes as one of the greenback’s “key statistical properties”, namely, its negative correlation to global growth.

That correlation, the bank explains, is attributable to the fact that “compared to the size of the US economy, the US Dollar denominates an outsized share of global trade volumes, cross-border lending, and risk-free assets [and] unlike most other currencies, it stands between many transactions in the global economy that do not involve the domestic market itself.”

The risk-free asset point is pretty straightforward. When appetite for risk is high (presumably during periods of robust global growth), appetite for USTs wanes, reinforcing the negative correlation between the dollar and the perceived health of the global economy. Here’s Goldman:

Treasuries account for about 85% of all sovereign debt rated AAA, and about 65% of sovereign debt rated AA or better. By contrast, the US accounts for 15% of global GDP according to the IMF (using PPP-based weights). In light of these facts, it is perhaps not surprising that as the negative correlation between risk assets and Treasuries (in price terms) has increased, so has the negative correlation between risk and the Dollar– higher US yields and Dollar weakness may reflect common portfolio shifts away from the world’s risk-free asset.

As far as cross-border lending is concerned, the idea is that during boom times, borrowers constrained by access to local currency loans will borrow in dollars instead and then use those dollars to fund, for instance, capex. But if that spending is done locally, the borrowed dollars will need to be converted, and that conversion (i.e., selling dollars and buying local currency), pressures the greenback. “The causation may also work the other way around”, Goldman adds, noting that “a weaker Dollar lowers the real cost of debt for international borrowers, potentially increasing their demand for credit.”

The global trade bit is pretty interesting. Here’s Goldman explaining how invoicing in dollars can effectively lead to a kind of tail wagging the dog scenario vis-à-vis global growth:

Conceptually the choice of invoice currency need not matter for global trade: the Dollar may simply serve as a means of translating between two other exchange rates. But it turns out that international trade prices are sticky in Dollar terms, such that fluctuations in the Dollar versus other currencies can influence economic activity over the short-run–an idea referred to in some academic research as the dominant currency paradigm. The mechanism works as follows: (i) the Dollar appreciates for an exogenous reason against all currencies (e.g. the Fed tightens); (ii) because trade prices are fixed in Dollar terms, the local currency cost of imports rises for all other economies; (iii) as a result of higher costs in local currency terms, import quantities contract, reducing global trade volumes and overall economic output globally. Because import prices for the US itself do not change (as they are also invoiced in Dollars), higher US demand does not offset weakness elsewhere.

Needless to say, all of the above is just further evidence to support the contention that after nearly five months of a steadily appreciating greenback, the world needs a break from dollar strength, especially in light of the trade backdrop and the U.S.-centric growth narrative.

That is, protectionism is threatening to undermine global trade and commerce and thereby torpedo the “synchronous global growth” narrative that helped buoy international risk sentiment in 2017 once and for all. Meanwhile, U.S. fiscal policy is exacerbating the disparity between the American economy and the rest of the world. Both U.S. fiscal policy and Trump’s trade war are ostensibly dollar positive to the extent they force the Fed to lean more hawkish than the committee might otherwise be inclined to lean.

So again, hope for more dollar weakness if what you want are more weeks like this one, where U.S. stocks make new highs thanks, somewhat paradoxically, to outperformance in ex-U.S. equities and a concurrent reduction in spillover risk back to a still ebullient Wall Street.

Oh, the good news from Goldman’s analysis is that thanks to the fact that the causation runs in both directions with regard to the dollar’s relationship to global growth, more tightening from the Fed need not necessarily drive further dollar strength if global growth is generally robust. On that note, we’ll leave you with one final passage from the bank’s Zach Pandl:

Firm domestic growth and rate hikes from the Fed may not be a sufficient condition for continued Dollar gains. As demonstrated by the Fed’s last tightening cycle in 2004-06, Fed tightening can be consistent with modest Dollar weakness if the tightening occurs alongside healthy global growth. Still, one lesson from history is that GDP growth alone is not enough: we should also be watching for signs that global trade volumes and cross-border lending activity are picking up. Our current expectation is that we will see these trends reemerge, and that the Dollar will see renewed weakness as a result.