1. The US growth and interest rates advantage should prevent a mean reversion to fundamentals
The persistent deviations of the dollar from its fundamentals recorded over the past few years may sound an alarm bell. The relative over-performance of US assets and the high hedging costs were the main reasons supporting the dollar premium against its fair valuations. In June 2020, Covid-19 shifted such balance overseas, allowing a repositioning to more underowned and dislocated assets. At that time, the dollar had lost two of its main cyclical drivers that featured in the recent past. Firstly, its growth premium compared to other G10 countries collapsed in the first half of 2020. Secondly, the Federal Reserve (Fed) removed the dollar rates advantage almost completely, which had made the greenback a profitable investment opportunity on top of being a defensive play. The Fed’s policy shift to an average inflation targeting (AIT) regime signaled in September 2020 has led to rising inflation expectations and added further pressure on real rates. This has reinforced investor confidence in a sharp and abrupt dollar sell-off.
Relative growth expectations have started to move in support of the US, which is now expected to lead the global economic recovery.
Since then, the picture has changed substantially. Unlike in June 2020, when the financial industry was fascinated by the potential structural fallout of the Next Generation EU plan for EU economies, markets have realised how strong the US economic rebound has been compared to other G10 economies. Consequently, relative growth expectations have started to move in support of the US, which is now expected to lead the global economic recovery. Our current expectations foresee US nominal GDP growth at 10% this year, well above consensus estimates.
The relative over-performance of US assets and the high hedging costs were the main reasons supporting the dollar premium against its fair valuation.
As history often repeats itself, it is interesting to draw a comparison with 2018 as current conditions are lining up to allow another dollar bull run. At that time -- and despite the dollar overvaluation being even more noticeable than today -- the dollar benefitted from what we deem the best combination of factors for any currency market:
- Fiscal loosening, enabled by the Trump administration’s tax cuts, boosted US growth and corporate margins; and
- Monetary tightening, as the Fed was normalising policy rates, added carry to US fixed income.
Both factors encouraged investor demand of dollar-denominated assets, regardless of its valuation. Today, growth is accelerating, while the Fed is highlighting its willingness to keep rates unchanged through 2023 despite upgrades to its economic outlook. It needs to persuade market participants that the monetary policy stance will stay accommodative in order to anchor market expectations. Meanwhile, the recovery should gain traction. Since Q4 2020, the Fed has welcomed the rise on the long end of the curve, both nominal and real, consistently with the progresses in economic activity and in the vaccine rollout campaign, which were difficult to imagine only a few months ago. We believe the Fed should keep a ‘wait and see’ approach, carefully managing any communication on forward guidance. However, investors should stand ready to face any communication change should data confirm what expectations are pointing to today. Market participants may test the Fed’s commitment to keep rates at historically low levels and will try to anticipate any possible rhetoric shift. As such, interest rate patterns – for both real rates and inflation breakevens – will determine dollar trends, possibly triggering dollar accumulation. Therefore, we believe it is worth taking a deep dive into the US rates framework in order to frame the dollar profile and highlight potential triggers to dollar stockpiling.
2. Dollar to remain weak against commodity-related currencies, but strengthen against low yielders
As the Fed is anchoring the short end of the yield curve, any improvement in growth and inflation dynamics should translate into higher nominal and real rates at the long end of the curve, suggesting the ‘exceptionalism’ of dollar-denominated assets is back. As such, US rates dynamics are back in the spotlight. Let us focus on US ten-year real yields and inflation breakevens. We analyse all possible US real yield and breakeven combinations and the resulting four regimes:
- Falling real yields and rising breakevens;
- Rising real yields and rising breakevens;
- Rising real yields and falling breakevens; and
- Falling real yields and falling breakevens.
In 2020, rising US breakevens and falling US real rates caused a persistent dollar sell-off, which was consistent with historical evidence. Those conditions need to be back to restart such a depreciating trend, but we believe they are unlikely to materialise in 2021.
According to our analysis, the dollar tends to sell-off when real rates fall and breakevens rise (green bars on figure 6), while it shows a mixed tendency when both real rates and breakevens rise (our current base scenario, blue bars). Finally, it appreciates against the entire G10 universe when real rates rise but breakevens fall (light blue bars). In 2020, rising US breakevens and falling US real rates caused a persistent dollar sell-off, which was consistent with historical evidence. Those conditions are needed to restart such a broad-based depreciating trend, but we believe they are unlikely to materialise in 2021. Today:
- Nominal rates remain well below their pre-pandemic level and we expect them to rise.
- Inflation expectations (i.e., breakevens) have repriced significantly since May 2020; we see some consolidation risk as we approach the second half of this year.
Under such circumstances, a regime of rising breakevens and falling real rates is unlikely to be experienced again in the short term. 2020 has mostly been distinguished by rising US breakevens and falling real rates. Against such a backdrop the dollar sold-off strongly against the entire G10 spectrum. Today, to see a continuation of such a trend, we would need to be back on that regime. However, it appears unlikely, as nominal rates have further room to go and breakevens have repriced meaningfully. Looking at those periods in 2020 when breakevens were rising and real yields were falling (namely, April-August and October-December), empirical evidence confirmed our results: the dollar depreciated strongly across the entire G10 spectrum, with commodity currencies outperforming strongly.
This year, we see both breakevens and real rates rising, thanks to US growth proving stronger than anticipated and the Fed’s average inflation targeting framework. In 2021, the dollar will face a mixed and challenging environment: it will be weak against higher yielders and commodity currencies, but stronger against the lowest yielders, mainly the safe havens such as the Swiss franc and the Japanese yen.
In 2021, the dollar will face a mixed and challenging environment: it will be weak against higher yielders and commodity currencies, but stronger against the lowest yielders.
As shown in figure 7, US ten-year real yields and breakevens have started rising together since early 2021 and year-to-date monthly FX performance has been consistent with the median returns experienced when both breakevens and real yields rise. The sharp depreciation experienced by the Swiss franc and the Japanese yen is due to their high sensitivity to rising US rates.