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August 22, 2017

Market Voice: Does the Solar Eclipse Imply an Eclipse of the Dollar?

by Thomson Reuters.

In contrast to the high-flying stock market, the dollar has been generally trending lower since the election. After making a modest new high in January, as shown below, the broad dollar index has been trending lower and is down roughly 7% from the peak and 3% from the pre-election surge level. The dollar is testing one-year lows on a trade weighted basis and is even weaker vs some individual currencies – especially, EUR and AUD. It is tempting to blame the Trump Administration’s anti-free trade and immigration policies as a source of the decline; but this would be overstating the case as the main driver of the dollar downtrend is relative economic performance.

As good as things have been in the US economy, they have been even better abroad. While the US stock market has surged to new highs this year, it has underperformed global equity markets. As is also show below, as the SPX lost ground to the MSCI global index it led the broad dollar lower – this performance link is made more notable by the fact that in isolation the weaker dollar should be good for equities by improving US competitiveness (more on this below). To the degree that relative equity performance reflects underlying economic growth, it also captures shifts in expectations on the speed with which central banks will tighten policy. On the US side of the equation – expectations on tightening have clearly moderated since the start of the year.

While the dollar’s decline seems apolitical, a “Trump” effect may have recently crept into the market. In particular, the dollar’s sharp drop in July seems exaggerated relative to the SPX underperformance. The dollar also has not benefited from the August SPX relative bounce. Adding fuel to the view that politics may be emerging as a factor, the credit default swap on US Treasuries started widening out in July about the same time that the dollar sagged.

US vs Global Equities and the Trade-Weighted US Dollar

Source: Eikon

Source: Eikon

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So Where Does the Dollar Go From Here?

The relation between equities and the dollar shown on the prior page suggest the weakness is overdone and the dollar is due for a rebound. The performance of the Treasury CDS shown above, however, suggests the dollar’s weakness is tied to Congressional approval of an increase in the debt ceiling. As noted, the CDS spreads widened in July with the biggest impact seen in the shorter-term 1- year spread. This implies the market is focused on the near-term disruption and technical default that could emerge if the government fails to raise the debt ceiling before October. There appear to be positive dollar prospects into year -end, but near- term gains will be tied to progress on the debt ceiling and a default – even if technical and temporary – would not be constructive.

The misalignment between USD and equities suggests a broad recovery of about 3.5% once the debt ceiling overhang is eliminated. Of course, the outlook varies for individual currencies. GBPUSD is in line with cross-country equity pricing while at the other extreme, as shown below, the AUD is vulnerable to a 10% decline. AUD may enjoy an additional boost from the dollar drop because of the feed-through to higher commodity prices – especially oil.

Where do you see the dollar in 6 months?

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All Ordinaries vs SPX and AUDUSD

Source: Eikon

Dollar Losing its Commodity Price Dominance

In principal, dollar movements have an inverse impact on commodity prices. Since virtually all commodities are dollar priced in global markets, a weaker dollar reduces commodity prices in local currency terms. Simple economics dictates that the lower local price will increase demand creating some pushback. The new equilibrium should result in some recovery in the dollar price but not enough to fully offset the impact of the decline so commodity prices are presumed to be inversely correlated with the dollar. The exception is agricultural commodities which are much more sensitive to supply conditions.

As shown below, the dollar apparently no longer has the pull in commodity prices that it once did – with the exception of gold. The one- year correlation between the dollar and crude was close to 50% a year ago and is now at 15%. The decline in copper correlation has been even more dramatic taking it down almost to zero. It is not clear why the dollar’s sway in the commodity world has diminished but may reflect some combination of the general down move in volatility in all markets and perhaps a move away from dollar pricing in global commodity markets. Gold may remain an outlier since it generally is treated more like a pseudo-currency than are other commodities. But, at least for now, a dollar rebound should have only a marginal downward pull on commodities.

Selected Commodity Price One-Year Correlation with the Trade-Weighted Dollar

Source: Eikon

Will a Weaker Dollar Help the Trade Balance

Even if the dollar rebounds in line with relative equity market prices, this will still leave it substantially weaker than a year ago. At a time when there is increased political focus on the US negative balance of payments and concerns that free trade may not be serving the national interest, one possible benefit from the weaker dollar is the potential that it will help narrow the trade deficit. The chart on the next page shows the year-over-year change of the real dollar (note the scale is inverted so a higher level is a weaker dollar) and the net benefit to real GDP growth from the real trade balance. While there is marginal evidence of a positive relation between the dollar and net trade, the connection is weak, especially in the short run. So even if the dollar fails to bounce back do not look for much benefit for trade.

Selected Commodity Price One-Year Correlation with the Trade-Weighted Dollar

Source: Eikon

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