Give me a place to stand,
and a dollar that’s trending,
and I can move the world
Archimedes, the Greek tinkerer, knew of the US dollar’s importance to global macro well over 2200 years ago, decades before Fed Chair Yellen was born. A man ahead of his time.
If you’re one of the very few who read my work then you know that I refer to the dollar as the world’s fulcrum.
This is no exaggeration. The US dollar is that important to global markets.
The deeper you get into the global macro game the more you realize nearly every trade is a derivative of a long or short dollar position.
Long Brazilian equities? You’re short the dollar.
Long airliners? You’re making a macro call on oil and thus the dollar.
Long volatility? You’ve got an embedded dollar call there.
Short inflation through duration? Then you’re long the dollar.
The dollar is important.
Why is this?
Short answer is the dollar is the world’s reserve currency. It’s what commodities and goods are priced in for global trade, and it’s the dominant global funding currency. The dollar is pervasive and it’s everywhere which is why the Fed swings the biggest stick of them all.
If you can figure out the path of the dollar then you’re starting from an advantaged point in assessing where the other major macro trades are headed.
It’s always my starting point when analyzing any market.
That’s what I’m going to spell out quickly here today. We’re going to run through some basic models for thinking about the dollar and then we’ll jump into the bearish thesis, the bullish thesis, and conclude with where in the argument I sit.
And just to make clear my current biases. Our team at Macro Ops has been short the dollar against AUD, CAD, since June 27th, until this last week when I closed out for profit.
I took these trades with the belief that they were countertrend moves. I was in the cyclical dollar bull camp but was bearish over the intermediate term, with the expectations of a 10% pullback due to technical, sentiment, and macro reasons.
Now that the move has played out, I need to update my view.
Some dollar models.
I’ve shared a more in depth piece on the way I think about FX that you can find here. In it, I hash out Soros’ arrows and the core/periphery model.
Today we’re going to talk about the “dollar smile” concept put forth by Stephen Jen of Morgan Stanley because it’s relevant to our conversation.
The theory is simple. It states that the dollar tends to outperform when the US economy is very strong (on the left side of the smile) or very weak (right side). And it does poorly when the US economy is just muddling through (middle of the smile).
Why is this?
Well the logic is straightforward.
The US trades at a “safety premium” relative to other countries.
Some might snarl at that and there’s a lot of gold bugs who think the US government’s debt blowup is imminent. But the reality is that relative to the rest of the world, the US has one of the most dynamic economies, highly liquid markets, (relatively) stable governments, decent rule of law, and again, we’re the world’s reserve currency.
When the US economy is performing well, investing in the US is a no brainer. And since well over 80% of the moves in the FX markets are due to speculative flows, this fact matters.
And when the US economy is very weak, the dollar performs well because it gets a safety bid. Money gets pulled back from overseas to within safer borders.
Most international funding is done in USD dollars. And when volatility increases and markets are perceived as more risky, these dollar loans are called back and Brazilian Reals or whichever, get converted into USD to cover the dollar debt thus putting upward pressure on the dollar.
But when the economy is in the middle of the “smile” and just muddling through, the dollar tends to perform poorly… why?
Well, the primary reason is that mediocre growth and low inflation is bullish for risk assets because it keeps the Fed steady and prevents them from raising rates too quickly.
So a steady Fed keeps interest rates low. These low interest rates suppress volatility and pushes investors further out the risk curve in search of returns. They go overseas to high growth emerging markets to play in their fertile fields.
Low growth and low rates lead to speculative outflows from the US which drive the dollar down relative to where the capital is flowing to.
There’s a reflexive relationship in these FX flows that starts to dominate.
This is because currencies make up the largest pie of the total return picture when investors put money into foreign markets.
So when speculative capital leaves the US because of low rates and slow growth, and then flows into, say, Latin America. It depreciates the dollar while appreciating the Latin American currencies. This drives up the total return of those investments in these EMs which then attracts more speculative flows (ie, reflexivity).
Here’s a short snippet from Soros on the mechanism.
To the extent that exchange rates are dominated by speculative capital transfers, they are purely reflexive: expectations relate to expectations and the prevailing bias can validate itself almost indefinitely… Reflexive processes tend to follow a certain pattern. In the early stages, the trend has to be self-reinforcing, otherwise the process aborts. As the trend extends, it becomes increasingly vulnerable because the fundamentals such as trade and interest payments move against the trend, in accordance with the precepts of classical analysis, and the trend becomes increasingly dependent on the prevailing bias. Eventually a turning point is reached and, in a full-fledged sequence, a self-reinforcing process starts operating in the opposite direction.
This is why currencies tend to trend for long periods of time once they get going. See the seven year USD cycle below.
Strong US growth = outperforming dollar. A very weak US economy = strong US dollar. And a muddling US economy = weak dollar.
I should point out an important point that I’m not sure Stephen Jen mentioned when he introduced this concept. But all of this is relative. We don’t care about the US’s economic growth on an absolute basis. We care about its economic picture relative to that of the rest of the world’s (ROW).
If the US is muddling at sub 2% growth but emerging markets are a dumpster fire, like they were following the GFC just up until this last year, then that’s still dollar bullish.
The idea is that investors have to perceive risk to be low and the reward to be well above the US’s premium, in order for capital to leave our beautiful shores and invest in a Chilean poultry producer.
The chart below shows this dollar smile relationship at work. Blue line shows the US’s growth relative to the rest of the worlds (ROW) and