One week / one topic: Wrecking ball, Dollar edition

What happened?

Since expectations of US rate cuts peaked at the beginning of 2024, the Dollar has performed strongly vs most other developed markets currencies.

While purported lead/lag relationships between exchange rates and interest rates can sometimes break down and lead investors astray, they essentially constitute two sides of the same coin from a ‘fundamentals’ perspective.

Following this playbook, the Dollar indeed appreciated over the last six months as investors adjusted their expectations towards ‘higher forever’ US rates.

The problem? The Dollar is increasingly turning into a wrecking ball:

• For the first time, the ECB has started to cut rates before the Fed while France’s far right wants a €2bn rebate from the EU. The Euro is left on shaky ground and its share of official FX reserves (currently ~20%) looks unlikely to increase any time soon

• Despite intervention from the Bank of Japan, the Yen is the cheapest since 1986 while local banks are left trying to stem enormous losses due to persistently high US interest rates (a la SVB)

The Dollar is simply (way) too big to ignore, and the potential for further casualties remains high.

Meanwhile – after the first presidential debate – investors have been reminded that a potential Trump victory could quickly lead to new trade tariffs and further fiscal abandon, a potent cocktail likely to further stir up FX volatility.

Should investors then jump on the Dollar bandwagon and ride the trend, hoping for further Dollar gains? Or is the move ‘overdone’?

Perhaps even more importantly, are there any investable second-order effects?

Our observations

• Fundamentals: Forward USD interest rate differentials – again, an imperfect signpost at best – are priced to remain positive (i.e. higher rates in the US than elsewhere) for the foreseeable future, as US growth outperformance is expected to continue.

• Price action: As for many other assets, FX trends can last for much longer that you can tolerate. Instead of pontificating about demographic effects or geopolitical events, investors might be better served by respecting momentum.

• Investor beliefs: The Dollar indeed has many flaws, but everyone knows that everyone knows that there is no credible alternative. Nothing lasts forever of course, but what would it take to challenge its supremacy?

So what?

Within the confines of our portfolio limits, we have been running higher-than-usual Dollar positions.

A key consideration is that – if positive equity-bond correlation is indeed a feature and not a bug of the current environment (admittedly, a big if) – the Dollar (red) might provide some protection should ‘higher rates forever’ fears bring back 2022-like weakness across assets.

Furthermore, we believe that – over time – global multi-asset portfolios should take into account the investable opportunity set’s structural features.

While the Dollar’s share of allocated FX reserves has been coming down (at a glacial pace) and it is vulnerable to concentration risk, it still accounts for ~60% of the total.

Like it or not, you can’t ignore it.

Second-order effects are notoriously difficult to identify other than after the fact, with the proverbial benefit of hindsight. Nonetheless, recent strength in ‘hard currency alternatives’ like Gold and Bitcoin is quite notable as it is uncustomarily happening at the same time as the Dollar has done so well.

Perhaps this is a sign that – in the face of runaway debt and dysfunctional politics – investors are increasingly looking at alternative destinations for their excess savings / reserves?

Should we get another massive round of fiscal and monetary largesse – especially in the absence of any countercyclical considerations, i.e. while there is no need for it because the US economy is actually doing quite well – investors at some point might conclude that enough is enough.

Time will tell of course, but – if possible – our hunch is that the stakes for the upcoming US presidential elections have just gotten even higher.