Ok, let’s recap the dollar narrative briefly.
Headed into 2018, the greenback stubbornly refused to respond to a favorable shift in rate differentials. That stubbornness was arguably attributable to two factors: 1) the worsening U.S. fiscal trajectory, 2) the idea that the Trump administration’s trade stance was a weak dollar policy by proxy.
In late January, Steve Mnuchin delivered what looked like the death blow for the dollar bull thesis when, in what he probably thought was a throwaway comment, the Treasury Secretary noted that “a weaker dollar is good for trade.”
Fast forward 10 months and the dollar is sitting near an 18-month high (first chart below) and spec positioning is the most net long since January 2017, when “long USD” was one of the consensus trades following the election (second chart).
(Bloomberg)
So what happened? Well, as it turns out, the collision of U.S. fiscal policy, monetary policy and trade policy all played dollar positive. Here’s BofAML’s Ethan Harris to explain how “the US is running a trifecta of dollar-positive macro policies”:
- Easy fiscal policy pushes up the dollar by boosting interest rates and stimulating imports. The new tax laws also create incentives to repatriate cash to the US and if these monies are not already in dollar assets, this could strength the dollar as well.
- Fed tightening also pushes up interest rates, boosting the dollar.
- And actual and threatened US tariffs strengthen the dollar as well. Tariffs tend to weaken imports, reducing US demand for foreign currency, and threatened tariffs add to global uncertainty, pushing up safe-haven currencies like the dollar.
All of those factors conspired with a notable divergence in economic fortunes between the U.S. and the rest of the world to further increase demand for USD dollar assets, boosting the greenback further. Then, in the final act, October’s plunge in crude prices lent further support.
Ok, with all of that in mind, recall that back in September, Morgan Stanley’s Hans Redeker suggested flows into the U.S. were essentially “hot” money, chasing after the above dynamics.
“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 wrote, 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.” In other words: USD “cash” was suddenly viable again as an alternative to risk assets thanks to rising U.S. short rates.
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On Thursday, Redeker was out with a sweeping new note that carries the not-so-subtle title: “Time to Sell USD.”
Redeker cites a number of factors to support that call. He kicks things off by reiterating his “hot” money thesis from February. To wit:
Recent inflows into the US are primarily short term, and thus prone to reversal. Interest rate differentials support a strong USD by offering healthy returns to foreign investors. Instead of strong inward foreign direct investment or other longterm flows, we see evidence that flows to the US have been into money market funds and are carry trade motivated. We expect these carry trade flows to reverse and flow out of the US as US growth slows.
Next, Redeker suggests that the marked divergence between U.S. growth and the rest of the world may have run its course and to illustrate, he uses relative performance of the Russell 2000 and the ChiNext (China’s gauge of small cap and Tech names).
“Small cap companies provide the backbone for both economies and it seems that optimism concerning the performance of US economy has decreased over recent weeks while China’s market now expresses a higher degree confidence, rallying 18% from its October lows”, he notes, before advancing what might very fairly be described as an out-of-consensus view as follows:
The message seems clear: the narrative is no longer about US-RoW growth de-synchronization, but rather about an improving Chinese outlook, which in turn raises doubts about USDCNH breaking higher. A USD long positioned market will increasingly find less support.
To be clear, there is a broad consensus that the “synchronous global growth” narrative is rapidly morphing into a story about a “synchronized global slowdown”, but the notion that the outlook is suddenly improving for China and that the yuan doesn’t have a date with a 7-handle (which seems implicit there) is debatable. In fairness, Redeker mounts a trenchant defense of that view.
Next, Morgan argues that widening credit spreads are not in fact the result of everyone suddenly waking up to poor balance sheet quality, but rather the result of swiftly tightening financial conditions. The read through for the dollar, the bank argues, is bearish:
At this stage in the cycle (as opposed to in earlier stages of the tightening and business cycle), monetary tightness translates more quickly and more directly into tightness in broader financial conditions. The USD may weaken as credit spreads widen, equity prices fall, and sovereign bond yields also begin falling amid disinflationary pressure and falling oil prices. Falling oil prices only increase bearishness on US credit, furthering this vicious cycle.
But shouldn’t falling oil prices be USD positive? Not right now, Redeker reckons, for the following two reasons:
- US corporates are increasingly leveraged, and oil sector firms remain highly leveraged. US credit spreads may widen as oil revenues decline. Rising corporate funding costs may undermine equity markets, causing prolonged underperformance in USD-denominated assets.
- The booming US oil industry helped the US economy outperform. This outperformance will fade as oil prices decline. The IMF estimates that the US has a small positive output gap, in contrast to the rest of the world. Capacity constraints and a positive output gap make the US more prone to inflation than other countries as the result of higher oil prices.
So, there you go. That, in brief, is the rationale behind Morgan Stanley’s “time to sell USD” thesis. You can take all of that – or leave it.
What we would note is that the best reason to be wary of the dollar over the longer term remains the “deplorable” U.S. fiscal trajectory.
When the next downturn finally comes along (i.e., if this expansion ever decides to die), fiscal policy will be exhausted and the U.S. will be running trillion-dollar deficits. That means it will fall to monetary policy to combat the downturn, setting the stage for the Fed to cut rates against a backdrop of a deteriorating fiscal position.
That doesn’t sound like a particularly bullish setup for a currency – the dollar’s reserve status notwithstanding.
