Last week, the dollar fell, much to the relief of ex-U.S. risk assets which have been laboring under the weight of a greenback that’s risen relentlessly since late April.
For quite a while in late 2017 and early 2018, the dollar stubbornly refused to respond to rising U.S. yields (in general) and increasingly favorable rate differentials (more specifically).
Two arguments were trotted out to explain the dollar’s refusal to rise with U.S. yields. First, ill-timed, deficit-funded stimulus has put the U.S. on a precarious fiscal trajectory that is anomalous by post-War standards.
Second, Trump’s adversarial trade stance was seen as a weak dollar policy by proxy. Steve Mnuchin underscored that assessment (accidentally) in Davos back in January.
On the way to parsing last week’s dollar pullback, we suggested those dynamics might be back in play at least in terms of what traders are thinking about. To wit, from “‘Call It Fate, Call It Luck’: That Dollar Pullback Everyone Was Begging For Is Here“:
It’s at least possible that i) renewed faith in the reflation narrative (thanks China!) and ii) the prospect that the monetary policy convergence theme (and maybe even the economic convergence theme) is about the reassert itself, are together creating alternatives to U.S. debt, thereby ushering in a return to the dynamics that persisted in late 2017/early 2018 when worries about the U.S. fiscal trajectory and the notion that U.S. protectionism is a weak dollar policy by proxy, together prevented the greenback from responding to sharply higher U.S. yields and increasingly favorable rate differentials.
Well, in a note dated Thursday, Morgan Stanley’s Hans Redeker says the following about all of this:
Within DM, USD-supportive yield differentials have reached a historic magnitude. However, this has not been sufficient to support USD. The DXY has lost 2.6% since mid-August and our four-factor scorecard predicts further USD weakness. Widening USD-supportive yield differentials should be seen in the context of rising capital import needs. We believe the current yield compensation offered by the US is no longer adequate to attract sufficient foreign funds to cover US capital-import needs. Hence, we posit that USD has to decline to attract international funds to the US.
Got that? Essentially, the U.S. fiscal position is now such that even the wide cushion offered by relatively juicy yields on USTs isn’t sufficient to compensate investors, especially on a hedged basis, so, the dollar needs take up some of the slack. That assessment comes amid a pretty steep selloff in Treasurys.
Morgan Stanley goes on to question the “quality” of USD flows. Specifically, the bank thinks the greenback has been driven lately by hot money flows fleeing assets that are vulnerable to Fed tightening.
“Much of the inflows driving the recent USD rally has been driven by ‘low quality’ flows, or short-term flows which are quick to reverse, as opposed to long-term flows like FDI, equities, and long-term bonds”, Redeker says, adding that “US inflows derived primarily from investors trimming their EM investments, as risk-adjusted returns in EM declined while the attractiveness of low-risk short-term investments into the US increased.”
Don’t tell any of this to the President…