Revisiting the case for dollar weakness
Having been dollar bulls for much of the past decade we tentatively called for a peak in the US dollar back in October, before expanding on the case for dollar underperformance at the last Global Fixed Income, Currency and Commodities Investment Quarterly meeting in December.
The arguments we made for dollar underperformance focused on an expensive valuation for the dollar that was no longer justified by fundamental factors. We focused on two key fundamental factors in particular that had driven the dollar up – the role of the dollar as a safe haven and the energy crisis in Europe. Over the last two months we have added the implications of the change in China’s approach to managing Covid to our list of fundamental factors weighing on the dollar.
As February begins, we review the reasoning behind our view on the dollar, and update our broader outlook, by assessing currency market valuations, fundamentals and technicals.
The expensive valuation of the US dollar has been a crucial pillar of our view on the currency markets, particularly given that valuation is one of the most widely accepted and reliable currency strategies over very long timeframes. While we acknowledge that the dollar’s valuation is less extreme today, following recent underperformance, we continue to view the dollar as overvalued – even allowing for the structural adjustment to valuations needed to reflect US energy independence following the exploitation of US shale a decade ago (Exhibit 1).
Looking back at the historical performance of quantitative valuation-based currency strategies supports the case that the dollar’s overvaluation will continue to weigh on performance. Periods of extreme valuation divergence that have caused significant drawdowns for valuation-based strategies have typically reversed quickly (an average of eight months over five observations) and have been followed by positive returns over the following five years.
Exhibit 1: USD valuation remains expensive
Valuations alone are rarely sufficient to change major trends in the currency market. As such, it was an inflection in fundamental factors that drove our call for a weaker dollar last year. We focused on two crucial factors: the energy crisis following the Russian invasion of Ukraine, and the role of the dollar as a safe haven.
The energy crisis in Europe has since moderated. European natural gas prices have fallen significantly as a result of the warmest winter that the northern hemisphere has experienced in decades. These lower prices and better-than-expected stocks of gas in storage reduce the transactional demand for dollars required to pay for gas deliveries over the remainder of 2023. As positive as this story remains for European and Asian growth prospects, the euro in particular has already recovered much of its underperformance since the Russian invasion of Ukraine. Overall, we regard the impact of the receding energy crisis as fairly priced by currency markets.
Our view on the dollar’s safe haven status, meanwhile, had focused on the dollar’s role as a portfolio hedge in 2022, at a time when bond and equity markets had both suffered a fall in value (Exhibit 2). When we look historically, we see the dollar has strong safe haven properties at times of high inflation, when investors struggle to find other deep, liquid markets that can act to mitigate the effect of equity beta on portfolios. Our balance of payments analysis showed the US dollar was supported by “hot money” flows in 2022, consistent with this demand from investors.
With inflation having peaked last quarter, we expected this safe haven demand for the dollar to reverse. Reviewing the current situation, speculative positioning in the dollar now appears much more neutral. At the same time, the ongoing moderation in inflation is boosting demand for bonds. This rotation into fixed income assets could exacerbate dollar weakness, due to the significant overweight position that global investors hold in US equities, and the tendency for investors to have high currency hedge ratios on bonds compared to equities. Overall, we expect asset flows to continue to weaken the US dollar over the remainder of 2023.
Exhibit 2: Shifting bond equity correlation has tracked prior valuation cycles
However, the moderation of the energy crisis in Europe and the reversal of safe haven flows are no longer the only fundamental factors weighing on the dollar. Over the last two months, China has accelerated the removal of Covid-era restrictions. We now expect to see growth recover strongly in China, resulting in higher imports from the rest of the world. Historically, non-US economies have had greater exposure to Chinese import growth, both through trade in manufactured goods and imports of tourism. We expect this relatively larger boost to non-US growth to support further relative underperformance of the US dollar.
Analysis of technical factors is a core pillar of our investment process. Historically, we have found consistent and additive returns are available to investors who follow quantitative mean reversion strategies. We also make qualitative judgements on the effect of consensus positioning, which can cause sharp moves in currencies against the consensus view even without fundamental justification. These technical factors can change rapidly and require a dedicated approach to active currency strategy to remain at the forefront of market developments.
Exhibit 3: Quantitative technical indicators suggest caution on the speed of the dollar’s fall
When we assess the current technical situation for the US dollar, our framework suggests a degree of caution is required in the near term (Exhibit 3). Back in 2022 our negative dollar view was somewhat out of consensus, but there is now far more coverage of some of the factors behind our view.
An active approach can capture the opportunity in the dollar
We continue to expect dollar underperformance over the balance of 2023, though likely at a slower pace compared to the last couple of months. While our technical framework highlights the possibility of a tactical rebound in the dollar, we would expect such a move to be relatively small due to the weakness of fundamental support. Our approach is to ensure positions are sized appropriately so we can sell into any rally in the dollar. We would expect active management of position sizing to be the key to success in capturing the opportunity the dollar presents in current markets, given weakening fundamentals and expensive valuations, but more favourable technicals.