Investors have understandably spent much of the past six weeks focused on the unprecedented collapse and subsequent rebound in stocks. What has garnered less attention is the asset that has not moved much: the dollar. But as in the story “Silver Blaze” by Sir Arthur Conan Doyle–the fact that a dog didn’t bark alerted Sherlock Holmes to the perpetrator’s identity–the absence of action in the dollar may be the critical clue for what many markets do next.
As I discussed back in December, a tighter dollar drove tighter financial conditions in 2018. However, recent months have witnessed more stable currency markets. After rallying around 8% from the April low to the August high, the dollar has traded in a 3% to 4% range. Why has it stopped advancing and what does this mean for the various asset classes? There are three trends to note:
1. Growth in the U.S. has probably peaked.
A year ago, a late-cycle tax cut induced an atypically strong, at least relative to the post-crisis norm, period of U.S. growth. Today that impulse is fading. Purchasing manager surveys peaked early last year and economic releases are no longer beating the consensus. This does not mean that the economy is headed towards recession but simply that growth has peaked, a reality reflected in lower 2019 and 2020 GDP estimates.
2. Slower growth + lower inflation = a less hawkish Fed.
Along with growth, both inflation and inflation expectations are moderating. Five-year inflation expectations–derived from the TIPS market–peaked in May at over 2%. Today they are a bit above 1.60%. As inflationary pressures moderate and expectations come down, the Federal Reserve has begun to signal a (potentially) more measured pace to future interest rate hikes, removing one of the key tailwinds for the dollar.
3. The dollar is no longer a crowded short, as it was a year ago.
Last spring, traders were generally positioned short the dollar and long the euro (see Chart 1). That trade has since unwound as European growth has been a serial disappointer. This suggests that the spring surge in the dollar, which represented a sharp reversal in sentiment, is unlikely to be repeated.
A more range-bound dollar provides some relief for stocks and other risky assets. In particular, a more range-bound dollar should benefit two asset classes that struggled in 2018: gold and emerging markets.
During the past three months gold has rallied around 5%, recently trading at the highest level since last summer. At the same time emerging market equities have started to outperform. Despite December’s volatility, during the past three months EM equities are actually up in dollar terms. In contrast, developed market stocks are down more than 5%. A dollar that neither barks nor bites, is probably the key ingredient to give cheap EM stocks a chance at a sustained rally.