In a US Dollar bull market with interest rates at zero, cash is rightfully dismissed as a non-asset class. But, when the US Dollar is in a bear cycle, things change, irrespective of what US interest rates are.
There are a handful of indicators we use to identify US Dollar bull and bear cycles. One indicator—the Laubauch-Williams (LW) Real Neutral Rate—has gained traction with the Fed and is often referred to as r-star. It is a measure of the real (after inflation) neutral interest rate that the US economy can handle without stimulating or restraining the economy. Over time, the LW Real Neutral Rate is one of the better signals for the US Dollar.
Every US Dollar bull market since 1970 has been marked by an increasing LW rate. In the chart below, I plot the LW Real Neutral Rate (blue line, left axis) against the US Dollar Index (red line, right axis). In the early 1980s the US Dollar bull market occurred with the LW rate rising from about 3% to about 4%. Similarly, the US Dollar bull run of the late 1990s occurred with the LW rate rising from just over 2% to just over 3%. The most recent US Dollar bull market has been no exception. While admittedly harder to see because the numbers are so small, the most recent US Dollar bull occurred with the LW rate rising from around -.5% to about +.3%.
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This relationship suggests the US Dollar bull run has come to a conclusion as the LW Real Neutral Rate has rolled over again. In the chart below, I focus on the last five years. Notice the US Dollar following the trend in the LW rate. The pop in the LW rate in the first quarter of 2014 led the 25% gain of the US Dollar from mid-2014 through early 2017. Notice also that the LW rate peaked in mid-2016, having fallen back by about 50bps in the last few quarters, leading the peak and decline in the US Dollar.
The fact that the LW rate has declined for three quarters in a row suggests this isn’t a temporary fluke. It is likely driven by the slow turnaround in oil prices. In the chart below, I plot the LW rate against oil prices. Simply, falling oil prices (red line, right scale, inverted) pull the LW rate (blue line, left axis) up. And, the reverse is true also that rising oil prices dampen the LW rate.
So, if we are now in a US Dollar bear market, driven by, among other factors, a falling LW rate and rising commodity prices, the good news is that cash is an asset class again. Which currencies should investors focus on? An easy place to start are those currencies with the tightest linkages to oil prices.
Let’s start in Asia. Among interesting developed market options for a cash allocation are the Australia Dollar, Singapore Dollar and New Zealand Dollar. In each chart below, I plot the US Dollar FX rate against oil prices, with the correlation shown in the upper right corner.
Among emerging market currencies in Asia, the most interesting are the Indonesian Rupiah and Thai Baht.
Moving to the Americas, the Canadian Dollar, Mexican Peso, Brazilian Real and Chilean Peso all look interesting.
Moving on to Europe, the most interesting currencies are Euro, Norwegian Krone and Swedish Krona.
While there are many asset allocation decisions that hinge on whether the US Dollar is in a bull or bear market cycle, one of the easier is currency allocation. An investor following an Anything but US Dollars policy has the chance to capitalize on the new US Dollar bear market. Cash is now an asset class again, and this creates new possibilities for alpha generation and risk management.