We believe the current market and economic structure, however, means that any US dollar rally in a global recession will be short, shallow or may not even take place at all. We explain our thinking below:

1. Relative real rates. The Federal Reserve (Fed) has been the most hawkish central bank in developed markets. The European Central Bank (ECB), Bank of England and Bank of Japan already stopped hiking interest rates (or haven’t even started in Japan’s case) at levels below the current headline inflation, while the Fed may continue hiking even though inflation in the US has fallen more quickly. Ex-US growth has slowed more rapidly and global central banks’ reaction function has shifted away from data dependency to being more forward-looking. With a strong fiscal expansion and a dis-saving consumer, the Fed hasn’t had this luxury.

This means that when the Fed starts to ease policy, it will be bringing rates down from a much higher real level. Relative rate differentials are a big driver of currency returns, and the Fed has a lot of wood to chop in a global downturn.

Figure 2: Real Policy Rates

The biggest pushback to this argument is that the US has more cuts priced than other central banks. It’s completely correct, in our view, to price in greater inversion in the US. The US consumer has been desensitized to interest rate hikes as households fixed their mortgages at low rates for 30 years…but this works both ways. A 25bps rate cut won’t encourage US homeowners to refinance their existing mortgage deal, whereas an equivalent cut in, say Australia, where the passthrough is immediate, increases disposable income immediately. In a recessionary environment, the US will need to cut deeper than other economies for the same level of stimulus.

Figure 3: Central bank pricing for 2024

2. The resumption of right way risk. A driving factor for US dollar outperformance in recent periods has been the poor hedging quality of bonds –bonds have been positively correlated with stocks because high inflation erodes bonds’ value and prevents central banks from cutting rates when growth weakens. In a global recession scenario, weaker aggregate demand will bring inflation down (and we are already far below inflation peaks) meaning that bonds are a good hedge again – taking the burden off the dollar.

Figure 4: Correlation between bonds, equities and US dollar

3. Fiscal impulse. The US hasn’t been shy about using fiscal policy to drive growth, and this could obviate the need for deeper cuts. However, it’s going to be harder to generate a positive fiscal impulse from here. The Democrats no longer control all branches of government and, outside of a deep crisis, bipartisan support for large fiscal spending is unlikely. Fiscal policy expansion is more likely in China (centralized decision-making) and Europe (greater Recovery Fund absorption).

4. Net international investment position. Historically, the US was a major exporter of capital, seeking risk abroad. When risk aversion increases, this money heads home and boosts the US dollar. Post-GFC (Global Financial Crisis), it’s more complicated. Large global savings, particularly in countries without deep domestic capital markets, have found their way to the US – particularly US equity markets, which have had most of the good equity stories since 2009.

This means the net flow back to the US is going to be slow or non-existent.

Figure 5: Net international investment position as % of GDP (1=100%)

5. Smaller current account imbalances. The scale of global imbalances as a proportion of global GDP is smaller than it was pre-crisis, which should limit global fx (foreign exchange) volatility. Long US dollar is a long volatility trade in a crisis, so lower volatility will reduce the US dollar’s appeal.

Figure 6: Global current accounts as % of world GDP

6. Finally, the Covid crisis caused a rush for US dollars at the expense of all other asset classes – including US Treasuries. Treasury market dysfunction was unpalatable to US authorities and measures have now been put in place to increase US dollar availability in times of crisis. Major developed central banks have standing swap lines with the Federal Reserve, and there is now precedent to establishing swap lines with smaller central banks in both developed and emerging markets.

The Fed also set up repo facilities for domestic and international holders of US Treasuries. If you want to raise US dollars in times of crisis, you no longer have to sell Treasuries – you can simply repo them with the Fed and they’ll lend you US dollars using Treasuries as collateral. This should reduce the degree of market panic if we head to the left-hand side of the smile.

Bringing this all together, we think any global recession or market panic that sees us move to the left-hand side of the smile should be faded quickly – the market reflex will be to own US dollars, but this presents an opportunity to take the other side.

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