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Of Dollar ‘Smiles’, Correlation Breakdowns And Other FX Notables

The dollar has flummoxed more than a few folks in 2019.

The dollar has flummoxed more than a few folks in 2019.

The common sense/simplistic assessment following the Fed’s dovish turn in January was that a newly-“patient” Jerome Powell “should” precipitate greenback weakness. But that assumption failed to account for two things. First, the Fed’s global counterparts were compelled to lean dovish too, and second, the US economy continued to stand out as the “cleanest dirty shirt” (and yes, I’m aware that’s one of the worst/tiredest market clichés of them all, but it works here), supporting the greenback at a time when global growth fears were proliferating rapidly.

This chart is pretty remarkable, even as it lacks any semblance of nuance.

It’s funny how the dollar’s behavior always seems easily explainable in hindsight despite the relative dearth of prescient calls beforehand. For instance, looking back on 2018, it’s easy to see how a combination of late-cycle stimulus in the US (and the relative economic outperformance it engendered), a hawkish Fed (as the committee attempted to stay out ahead of a possible economic overheat), dollar+ repatriation effects, favorable yield differentials and a worsening outlook for RoW economies was supportive of the greenback. But if you go back and look at the commentary from January 2018, a lot of what you’ll read found folks focusing on the idea that Trump’s combative trade stance was a weak dollar policy by proxy and that the US fiscal trajectory was deteriorating rapidly. Both of those things are true (especially the latter point), but they were wholly insufficient to overwhelm all the factors that conspired to push the dollar higher starting in mid-April of last year.

In any case, the point is that folks get this wrong pretty often and currently, there’s considerable angst about the apparent disconnect between, for instance, the dollar and plunging US yields and also about the discrepancy between the rangebound greenback and crude, which has obviously surged off the Q4 lows. In a note dated Thursday, for instance, JPMorgan flags “apparent breakdowns in cross-asset correlations”, including, but not limited to, “this year’s jolt in stock prices but drop in bond yields [and] the significant drop in US yields but only modest decline in the trade-weighted USD plus USD strength versus most G-10 pairs.”

As alluded to there, some of the dollar story can be explained away by the greenback’s performance versus G-10 currencies compared to how it’s fared against EMFX. Here’s a simple example:

As Bloomberg notes, “while much is being made of the dollar’s failure to decline, the ‘worrisome’ divergence around the greenback is the difference between performance of developed-market currencies against it versus emerging-market ones.”

Speaking of the dollar and EM, Nedbank’s Mehul Daya and Walter de Wet have some thoughts on all of this. This is Nedbank so it’s couched in terms of the outlook for the rand, but as you’ll see, it has broader implications. To wit, from a Friday note:

We use the “dollar smile” framework to visualise and contextualise the evolving macro-environment and the dynamics of the USD. Chart 1 is a visualisation of the “dollar smile” framework. Within the “dollar smile” context, there are three key points.

Point a: “Strong US economy” – The US’ economic growth is robust and outperforms that of the rest of the world, attracting capital flows favouring the USD. Added to this, the Fed’s hawkish monetary stance (inflationary pressures) favours further USD strengthening (and as a result, EM currency weakness – including the rand).

Point b: “Synchronised growth” – Global growth is synchronised. The US economy is growing, but inflation remains stable, and as a result, US monetary policy is neutral. This environment favours a weaker USD, along with low volatility, which bodes well for investors’ risk appetite. This also favours more risky carry trades (and as a result, EM currency strength – including the rand).

Point c: “Synchronised slowdown” – The US economy, along with the rest of the world, enters a slowdown; the Fed and other policy makers attempt to reflate the global economy by easing monetary policies. However, investors’ risk appetite wanes. De-risking by investors favours safe havens such as the USD, JPY and CHF. This comes at the expense of carry-trade strategies (and as a result, EM currency weakness – including the rand).

We believe the world economy is past point b and moving towards point c.

As such, in terms of a multi-month view, we believe the global economic cycle suggests one should consider a general weakening bias when dealing with EM currencies, including the rand.

For their part, BofAML suggests that curve inversion in the US “may foretell USD weakness ahead”, supporting EM FX carry trades.

“Time and again EUR/USD empirically turns out to be the most important statistical determinant of EM asset prices not just in local currency”, the bank wrote this week, adding that “the year after yield curve inversion in the US can be a good time for EM [as] a more dovish Fed props up risk assets but keeps a lid on the USD.”

If you look at the last two cycles, EMFX either performed well or trod water over the year following curve inversion stateside. “In 2000 EMFX managed to stay flat over the year after inversion as carry offset damage from moderate USD strength”, the bank notes.


Goldman has some thoughts too. In the traditional Friday evening “Global FX trader” piece, Zach Pandl and co. lay things out as follows:

From a selection standpoint, we would highlight three buckets of currencies. First, MXN, ZAR and RUB screen well on a “carry plus value” basis, but not without idiosyncratic risks in each case. Second, while less-attractive from a valuation perspective, INR and IDR feature both high carry and lower volatility than most EM high yielders and, with general elections coming up in both places, market-friendly outcomes could well see the currencies overshoot to the strong side of fair value estimates. Third, BRL and CLP are two currencies where the nominal carry is low, but levels are compelling after a few weeks of underperformance—if Chinese growth improves and commodity prices remain firm, these currencies could appreciate.

Meanwhile, all of this plays out against a backdrop where the yuan’s “politicization” in the Sino-US trade talks looks set to usher in a period of calm just as the Chinese economy wants to inflect. In fact, the 1-year implied vol. premium for USDCNH has now disappeared and turned negative for the first time in seven years.


“We believe the ongoing trade talks with the US and even discussion over a currency agreement is politicizing CNY and suppressing volatility”, BofAML’s Claudio Piron wrote on Thursday, adding that “another key factor stabilizing USD/CNY is the improving interest rate spread differentials in favor of CNY.”

Read more about the rumored “currency agreement”

As US Demands Yuan Stability In Trade Talks, Let’s Go Insane Again

As usual, you can make of the above what you will (and there’s a lot you can make of it), but where the dollar goes from here will be just as critical as it ever is when it comes to dictating the fate of risk assets. One imagines we’ll continue to see the US president struggle with the inherently contradictory goals of overheating the US economy at the possible expense of global stability on one hand, and demanding a weaker dollar on the other. Throw in that same US president’s desire to drive oil prices down to about $15/bbl and you’ve got a pretty complex (read: inconsistent) narrative on your hands.

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