Pay attention to the US Dollar

October's global sell-off in risk assets served as a warning that the dollar's 2018 uptrend is still a headwind that is dampening risk appetite.  This combination of dollar strength and global equity market weakness returned in late January of this year after a one year reprieve following the greenback's 2017 top.  This strongly suggests that future global equity market returns are likely to be lackluster until the dollar's current move higher ends.  Please see, Keep your eye on the dollar as an indicator of risk sentiment, for a long-term analysis of this relationship.  As for this month's post, the focus will be squarely on this ongoing bout of USD appreciation and what its subsequent direction could mean going forward for US & global equities, credit markets, Oil, inflation expectations, and US monetary policy.

A strong dollar continues to coincide with poor global equity performance.

• UUP (US Dollar Index Bullish Fund) topped on January 2017 (vertical purple line) and bottomed in the final days of January 2018 (white vertical line).  Between these two dates, the DJIA rose by roughly 33% while the Chinese FXI Index Fund outperformed to the tune of 50%.  With the dollar breaking down below multi-year support, equity markets were experiencing a parabolic surge in the latter stages of that particular advance.  
• Unfortunately for risk assets, that dollar decline resulted in a false breakdown and a rebound back into its prior multi-year range. Although US equity markets have been roughly flat (green horizontal line) during this period of USD appreciation, EM risk-assets have fared far worse with the FXI having fallen nearly 28% at its recent October low.
• Heading into October's violent equity sell-off (blue vertical lines), the UUP had resumed its uptrend after consolidating over the summer.  By the end of the month not only did the DJIA breakout failed, but the US averages lost 10% while the FXI fell by 13%.  It goes without saying that improved equity market performance will likely require an end to dollar strength.

Since the 2018 USD bottom, global credit spreads have widened while Oil has come under pressure.

• This weakness during a bullish USD phase is not unique to global stocks.  Even though US credit spreads remain tight, they have widened in the rest of the world throughout much of this year.  Given that this relationship between the US dollar and foreign spreads has held since the late 1990s following the Asian and Latin American crises, this should be the case for the time being.  
• Much like rest of the world credit, Oil's uptrend has also been halted by the greenback.  For obvious reasons this is particularly detrimental for the currencies and financial outlook of Petro-states.  Moreover, since the start of this year market participants have also begun to anticipate the potential for lower inflation as well
• With all that said, global spreads have yet to widen anywhere near levels that have signaled major distress in the past.  Meanwhile the declines in oil and inflation expectations have been contained thus far.  Then again, should the dollar's strength persist, the fall in global credit and oil markets along with inflation expectations may have much further to run.  Like equities, this will depend on the direction of the greenback going forward.  

The Fed's balance sheet & rate differentials are driving the dollar

• In response to the Global Financial Crisis and recovery, the Fed has expanded and now contracted its balance sheet in a way that seems to coincide with moves in the dollar's exchange rate.  As the first chart shows, the year-over-year rate of change in the EUR/USD exchange rate has tracked the year-over-year rate of change in the reserve balances held by depository institutions at their regional Federal Reserve banks.  The latter is a direct byproduct of adjustments to the path of the Fed's balance sheet.  
• In other words, during periods where the Fed has increased their pace of balance sheet expansion (during the first halves of QE) or reduced their rate of balance sheet contraction (the pause in 2016-2017), the dollar has tended to depreciate.  On the other hand the dollar has trended higher when the Fed has either tapered (2014-2015) or increased the pace of balance sheet reduction (2018).
• Monetary policy expectations also manifest themselves in forward rate differentials.  When the dollar appreciations (depreciates), the difference between US forward rates (6 months ahead) and Euro forward rates tend to rise (fall).
• Pending the persistence of these relationships, the USD and forward interest rate spreads should remain supported as long as the Fed's balance sheet shrinks at its current pace or faster.  If the Fed's balance sheet were to decline on a Y-o-Y basis but more slowly going forward, the dollar's current move could weaken while Euro forward rates climb relative to their USD counterparts.
• Importantly, none of this implies that the long-term uptrend in US risk assets since the GFC has been primarily driven by the Fed's balance sheet in part via the dollar.  Dollar depreciation (appreciation) has serves as a tailwind (headwind) to US equity market performance, but the ongoing bull market has mainly been propelled by strong US nominal GDP growth and corporate earnings.  Then again, an end to the dollar's current strength would certainly be a welcome development for global equity and credit market investors.   

The Bull & Bear case: Given that the dollar and risk-asset markets may be heading into a very important junction or even an inflection point in 2019, the following summarizes a potential bullish and bearish intermediate resolution.   

Bullish Scenario:  The 2018 USD uptrend hits resistance near its 2017 peak and the uptrend falters.

• US equity indices break out of the box (above January & October 2018 highs) & begin a new uptrend in what continues to be a cyclical bull market within a secular bull.
• Global equities put in a bottom, rebound higher, and begin to outperform their US counterparts.
• Global credit spreads start to tighten as investors reach for yield.
• Oil finds support & displays relative strength against US equity indices.
• US Inflation expectations stabilize near or above currently levels.

Bearish Scenario:  The 2018 USD uptrend eventually surpasses the 2017 top as it attempts a multi-year breakout.

• US equity indices break below the box (October & February lows).  This would likely result in quarterly & monthly (cyclical) trend indicators flipping negative.
• Global stocks remain under pressure which may produce an acceleration in the ongoing downtrend.
• Global credit spreads widen and eventually risk reaching panic levels.
• Oil prices follow risk assets lower.
• Inflation expectations rollover as market participants start to price in lower future inflation.

Thus far the USD appreciation has mildly tightened global financial conditions and concentrated risk aversion to assets outside of the US.  With the Trump administration's fiscal expansion, the pace of US nominal GDP growth has surpassed the previous post-GFC highs lifting corporate earnings in the process.  Therefore, it shouldn't come as too much of a surprise that US equities and credit markets have hung in there while foreign stocks have corrected more forcefully with their credit spreads widening.*  The worry going forward would be an outcome where the dollar breaks out beyond its multi-year sideways range as this would almost certainly usher in a dangerous phase of risk-aversion.  In this context, the October rout would only be the start of a potentially much larger decline.

Conversely if the dollar were to burn out at the top the long-term range, US risk-assets may be well positioned to continue their cyclical uptrend in 2019 after consolidating their 2016-2017 gains during much of 2018.  In a way, this pause in price will have reset valuations given that earnings and economic growth have improved materially over the course of the year.  Presumably one of the most bullish possibilities entails a big dollar breakdown that sees global indices begin their cyclical or even secular moves higher after nearly a decade of underperformance.

Therefore, it goes without saying that the dollar's direction bears watching.  In the coming months or years depending on when this multi-year consolidation resolves itself, markets may be on the cusp of a secular move higher or lower in the US dollar.  Seeing as the greenback anchors 70% of the world's currencies and with 11 trillion worth of dollar denominated debt issued by non-bank borrowers outside of the United States, its next move could spell either much needed relief or far greater pain than what we have recently witnessed since the beginning of  2018.  Thus, its path will not only determine the fate of risk-assets but also the global economy, which is precisely why this writer considers it the most important chart in the world.  Pay attention to the USD.

*Even though the fiscal expansion has boosted corporate earnings and sales, the dollar drag has offset some of the positives as over 40% of sales growth for the S&P 500 derives from abroad.  This is particularly the case for the information technology and energy sectors and less so for healthcare and financials.