The Dollar Story

It was happening again on Tuesday.

“It” means an unwelcome easing of financial conditions courtesy of a market predisposed to celebrating incremental evidence of peak inflation.

The knee-jerk reaction to a very soft (versus consensus) read on wholesale prices unleashed another simultaneous rally in stocks and bonds, and, crucially, more dollar weakness.

It’s impossible to overstate the importance of the dollar story. The greenback was already on the back foot headed into the US PPI data, and pressed lower as soon as the cool print hit the tape. It subsequently trimmed losses, but that’s not the point. The point, rather, is that “peak inflation,” “peak Fed hawkishness” and “peak dollar” are all the same story.

The figure (above) is the simplest possible illustration of “peak dollar.” Trust me when I tell you that people who make charts all day and/or whose job it is to, for example, run Bloomberg’s real-time blog, have spent hours telling the same story from every conceivable angle, and using every conceivable visual aid.

The important point is that much of what ailed markets over the past several months was in some way, shape or form related to the dollar’s relentless ascent, which was, in turn, related to a relentless Fed taking its cues from relentless domestic inflation. As the dollar pressed ever higher, it delivered a terms of trade shock to Europe and Japan (for example) amid elevated commodity prices, thereby undermining the fundamentals at a time when rate differentials were already unfavorable for the euro and yen. Dollar strength was insult to injury for the pound, which came under siege from Liz Truss’s haphazard, and extremely ill-advised decision to challenge the bond vigilantes just as the Bank of England was keen to sell down its stock of gilts. And then there was the yuan, which sank to a record low, and on and on. All of that created a pervasive sense of angst across markets, which traders and investors roughly described in terms of “breakage.”

So, any respite from tyrannical dollar strength is a critical input for risk appetite. “At the highest level, the sudden lurch into the ‘past-peak US dollar’ narrative [predicated] not just on soft US CPI and the implications for a lower Fed terminal rate, but also on the China shift, alongside a warm European winter easing the worst fears of an energy crisis, remains at the core of the ‘trend / momentum’ unwind, with USD longs capitulating against G10 and EM crosses,” Nomura’s Charlie McElligott said Tuesday. That acts as “an ‘impulse easing’ in financial conditions, providing a further macro catalyst behind the brutal squeeze in legacy trend shorts in equities and bonds,” he added.

Charlie cited the dramatic easing in financial conditions unleashed last week by the CPI report, and noted that we’re currently witnessing an easing impulse roughly equivalent to two Fed cuts or the removal of two Fed hikes, whichever way you want to look at it (figure below).

If the rates re-pricing holds in the face of Fed pushback (earnest, feigned and otherwise), it’ll perpetuate an unwind in 2022’s trend trades which could, in turn, drive more of the same, particularly if there’s covering in legacy rates shorts, for example.

All of this remains counterproductive for the Fed up to and until the “aha moment,” when the details of a given month’s CPI report suggest that the word “progress” is no longer merely a relative term.