Keep your eye on the dollar as an indicator of risk sentiment

Last month's post, Are the signals that usually precede cyclical downturns present today?, pointed out how the current financial environment is not (yet) reminiscent of prior cyclical economic tops that ushered in major corrections in risk assets.  Despite the ongoing correction/volatility in global equity and commodity markets,

• the yield curve is still positive and above the January 2018 lows,
• the 10-year treasury yield remains in an uptrend (a sign of improving growth and inflation expectations),
• high yield credit spreads are still very low and have yet to widen materially,
• longer term moving average trends in equities still remain favorable,
• aggregate economic data suggests that the current upswing in NGDP remains intact.

With all that said, it is certainly possible that in hindsight the February risk-off move could eventually be understood as the beginning of a major economic and financial market correction rather than normal volatility in an ongoing uptrend.  In such a case, it is more likely than not that the aforementioned positive signals would all first flip negative.  This would provide attentive market participants with the same warnings that occurred before the two preceding economic downturns.  As of today, it is too early to suggest that dire outcomes are more likely than favorable ones.

Although the dollar's role in gauging risk sentiment has been explored countless times in this blog, (here, here, here, & here), the current correction in global risk has coincided with a counter-trend rally in the greenback against a broad range of currencies.  This post seeks to show in greater detail how the future path of the dollar could prove decisive in determining whether risk markets are on the cusp of much bigger gains or are on the verge of breaking down.

1.) A strong (weak) dollar has coincided with poor (positive) global equity performance.

• Between March 2000 & October 2002, the Wilshere 5000 Index fell nearly 50%.  Meanwhile the broad trade weighted US dollar index appreciated over 10%.
• During the bull run up to the 2007 top from the October 2002 low, the equity index rose roughly 130% while the dollar depreciated +20%.
• The Global Financial Crisis ushered in an equity index low in March 2009 which marked another 50% plunge as the dollar spiked +20%.
• Although the dollar's most recent accelerated +20% move higher between July 2014 to January 2016 did not produce nearly as violent a reaction in equities, the latter still performed poorly.  The major equity indices were flat to slightly down.
• Not surprisingly equities have since exploded 60% during the dollar's most recent retreat.
• As can be seen in the final chart, the all-world ex-US equity index has produced similar gains and drawdowns during such periods. 

2.) An uptrend (downtrend) in the USD is a headwind (tailwind) for commodity prices and inflation expectations.

• Similarly to global equities, the crude oil boom & bust cycles have been intimately tied to the trends in the USD.  In a sense, crude acts as a currency for oil producing nations.
• Interestingly, the dollar's current three year potential topping process is reminiscent of the 2000-2003 top.  Much like then, today's price action in crude seems to be tracing out a similar bottoming pattern.

• As seen here, the lows/highs in precious metals and commodities have occurred nearly at the same time as major highs/lows in the broad dollar index.
• Similarly to oil, the sideways price consolidation in the precious metal and commodity space may be hinting that a big move is to come in the months and years ahead.  It goes without saying that the direction in which this resolves itself strongly depends on whether the dollar continues its current downtrend or reverses towards its 2016 top instead.

• Understandably given the inverse relationship between equities and commodities relative to the USD, inflation expectations also exhibit similar behavior.
• If the dollar breaks down further from here, expected inflation should rise above +2.4% whereas a sustained dollar rebound could see this inflation measure collapse to their 2016 lows of sub 1.8%. 

3.)  Interest rate differentials drive the dollar.

• Both the longer term and short-term charts show that the USD FX rate has a strong relationship with interest rate differentials. 
• Improving nominal global growth expectations results in nominal interest rate outperformance relative to US short rates.  This has corresponded with dollar depreciation and risk seeking behavior.
• Following the 1990s Asian and Latin American crisis, dollar appreciation has either been the cause or effect of global financial tightening and risk aversion.
• In light of the charts above, should nominal global growth disappoint going forward or if global monetary conditions tighten materially (whether due to the Fed, ECB, BOJ, PBOC) policymakers risk provoking a destabilizing rise in the greenback.  In other words, it's difficult to see the continuation of the current global growth momentum without further dollar depreciation.  Given that the US dollar anchors 70% of the world's currencies, this should come as no surprise.

Concluding remarks:

Respite the rhetoric from within and outside of the US that a dollar depreciation ("debasement") against a broad range of currencies spells doom and gloom, the above charts strongly suggest the opposite.  It is not a weak dollar that has traditionally coincided with market turmoil, but a strong one.  Simply, past dollar uptrends and surges have occurred in conjunction with declining or underperforming global equities, commodities, and inflation expectations (see the January post for more red flags that usually occur concurrently).

The United States consolidated financial system as a whole issues short-term safe securities while acquiring higher yielding less liquid riskier assets issued from abroad.  In this way, the United States can be understood as a global insurer or banker to the rest of the world.  In good times of improving global growth expectations and risk taking (2016-present), the price of low risk US dollar denominated securities (the insurance claims) declines relative to riskier securities.  This manifests itself via a falling USD against a broad range of currencies as well as declining safe treasury bond prices.  In such periods, global entities are incentivized to fund economic growth by issuing risky securities as their currencies appreciate, credit spreads narrow, and equity markets rise.  In this sense, trends in the dollar serves as a great indicator of risk sentiment.

On the other hand, the opposite occurs in bad times particularly in periods of market distress as global market participants rush to the greenback and US treasuries for safety.*  As witnessed during the Great Financial Crisis, a surging dollar and rapidly declining treasury yields incentivizes (forces) the global insurer to respond by buying the risk that the ROW is selling while selling more insurance.  These are the reasons why the Fed's balance sheet and treasury issuance exploded higher as opposed to misplaced (wrong) theories of government profligacy or Fed monetary mismanagement.

In summary, it is not surprising that the USD has recently put in a (temporary?) bottom as risk assets have sold off following a strong uptrend.  Should the dollar's countertrend move continue or turn into a more durable move higher, risk assets will very likely remain under pressure.  However, if December 2016 marked an intermediate/long term top in the broad trade weighted US dollar index where it breaks below multi-year price support levels (roughly $115-$120), global risk assets would be set up to rally for possibly years to come.  Although right now the balance of evidence suggests the latter is more likely than the former, red flags will begin to signal should the dollar defy its current downtrend by moving back towards 2016 highs ($128).

Keep your eyes on the greenback.


*The US dollar and treasury securities are the financial equivalent of life rafts.  When the Titanic is sinking, the price of life saving flotation devices naturally skyrockets.  As the perceived probability of such potentially disastrous events increase, defensive actions by market participants can be visualized by a price uptrend in lifeboats/vests.