Explaining our bearish outlook for the dollar

Based on our analysis, the trade-weighted (TW) 2Y swap rate differential accounted for nearly half of the USD variation during the first episode (see chart II). While further widening in the spread continued to provide support to the dollar during the second episode, we find that economic growth divergence was the main driver of USD strength in October (see chart III), followed by the flaring up in risk aversion. We take these factors in turn.

Rate differentials: too stretched in favour of the USD

The rate differential between the US and the RoW (rest of world – here we focus on the seven main US trading partners, using the same weights as in the Fed’s dollar index) has widened, driven by both a repricing of Fed rate expectations higher and still very benign monetary policy expectations for the rest of the major central banks. In fact, on a TW basis, the swap differential is the widest it has been since 1999 (EUR inception), something which – as we argue below – we do not feel reflects developments in relative economic dynamics.

While we agree with the market that has started repricing higher the Fed’s tightening for next year (we expect three 25-bps hikes), we think investors are too complacent in their pricing of monetary policy paths for the other major central banks. Growth/labour market and to a certain extent inflation developments do not justify such low levels of expected policy rates one to two years out, especially when the starting point is either near-zero or negative rates.

There is a historic relationship between swap rate and unemployment rate differentials – with the intuition being that a tighter labour market (lower unemployment rate) warrants tighter future monetary policy. For example, when the US-RoW unemployment rate differential falls (either because of stronger momentum in the US labour market or weaker momentum in other major economies), the US-RoW swap spread rate differential widens, and vice versa. However, this time the unemployment differential is moving against the US, while US-RoW swap rate spreads keep on widening (see chart IV)

During the recent years of disinflation (and the “deflation scare”), this widening of interest rate differentials was engineered by unconventional monetary policies implemented by central banks (for example, the ECB’s QE) that wanted to keep financing costs low in an attempt to revive demand-led inflation by supporting investment, the labour market, and wage growth.

However, the indications so far suggest that 1) labour markets in these economies are becoming tighter; 2) wage growth has started picking up (see chart V); and 3) central banks are approaching the end of asset purchases (in all likelihood, the ECB will terminate QE at the end of this year).

Effectively, this leaves us with a significant dislocation in the market: the US-RoW interest rate differential is too wide given relative economic developments. We believe this will resolve itself by the differential narrowing, which should generate downward pressure on the dollar.

US economic outperformance largely a result of the fiscal stimulus

As discussed previously, one of the driving forces behind this year’s dollar appreciation has been the implementation of the US fiscal stimulus package. This is because the immediate impact has been positive on domestic growth inviting portfolio flows to US assets and raising US yields, both of which have lent support to the currency.

The issue here however, is that the timing of implementation was rather poor because the economy was in no need of fiscal support as it was operating at near full capacity. Once one adjusts the US budget deficit by taking into account the output gap (now around zero), one finds that this adjustment results in an almost unprecedented deterioration in cyclically adjusted deficit.

Once the transitory effects of the stimulus start fading (probably towards mid-2019), the US economy will find itself with a sizeable twin-deficit problem (C/A balance projected to be around -3% of GDP and budget balance close to -5% of GDP) that is likely to generate upward pressure on US risk premia.

Having ripped the (short-term) benefits of the fiscal policy, forward-looking investors should very soon start pricing these developments, requiring a lower USD to compensate for the higher risk premia (see chart VI). This is especially more so now that the US mid-term election result suggests gridlocks in Congress and evaporating expectations of additional tax cuts.

Defensive risk not a barrier to dollar downside

Our working assumption is that the global economy is currently in a phase of a slowdown where risk will trade on the defensive. However, we expect neither a major downturn nor a significant and sustained risk sell-off (reminiscent of that seen in October of this year).

Looking historically at periods of growth slowdown suggests a varying performance for the USD. Since 1997, the average quarterly performance of the TW USD in slowdown phases is around 0.5%, with considerable variation through periods. During 1997-2001, the dollar made considerable gains, but this was a period when EM growth had been decelerating sharply (from 1994 to 1998) on the back of multiple EM crises and significantly higher Fed rates.

During 2006 and 2007 however, the USD sustained heavy losses, as global growth was robust. Today EM GDP growth is expected to stabilise, while foreign currency debt exposure is lower and at lower (compared to the late 1990s) USD financing costs.

In that sense, we think that risk trading on the defensive may provide only very marginal dollar support that will be more than offset by the corrections in interest rate differentials and the medium term impact of the ballooning US deficit.

Risks to our 2019 bearish view

We see four risks to our central scenario:

• Risk 1: Inflation in the US surprises significantly on the upside and the Fed reacts too aggressively, providing renewed support to the dollar.
• Risk 2: A major global downturn (potentially due to an escalation in US-China trade disputes, a widespread EM crisis, an exogenous shock, etc.) that leads to a sharp sell-off in risk, and the markets respond by seeking the safety of the USD.
• Risk 3: The impact of the US fiscal policy is longer-lasting than we currently think, in which case US growth continues to be boosted by the stimulus impulses, strengthening demand for dollars on the back of ongoing growth divergence.
• Risk 4: Frictions between Italy and the European Commission escalate significantly leading the market to (a) start repricing a meaningful redenomination risk into EURUSD; and (b) maintain (or even widen) US-RoW interest rate differentials.

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