Ear to Ear Smiling Dollar – Mike Dolan


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LONDON – Whether investors run for the hills or not after last week’s earthquake, the episode provides a glimpse of where to run for shelter – and the US dollar has dominated.

Dollar cash has regularly provided a safe haven during times of global financial stress in the past – most recently, when the coronavirus pandemic unfolded in March of last year.

Concern over a possible default by giant real estate company China Evergrande – and even fear of spillover effects on regional real estate companies, high yield debt markets and banks – cannot be ignored. – not quite on this scale.

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But worries sufficiently triggered the sharp pullback in global equities this month, and the dollar was one of the few clear winners during the turmoil.

While this market correction has been widely predicted – with a majority in a recent survey of Deutsche Bank customers saying they expected a 5-10% correction by the end of the year – the fall the MSCI All Country Index this month nearly hit 5% on Monday.

The nerves for real estate in China are far from over and financial volatility indicators are at their highest for months.

The dollar has performed impressively as a safe haven, with its main trading index gaining more than half a percent over the past week – and it has risen nearly 1% against gold, moreover 1.4% against the pound sterling, almost 7% against Bitcoin.

Rival havens such as the Japanese yen and the Swiss franc have matched or surpassed this in the past seven days – but the dollar is clearly inflating independently.

Of course, not everything is due to stress. The other big event of the week, the Federal Reserve’s latest policy-making meeting, provides alternative fuel for the currency.

And some monetary strategists see the dollar now receiving a special double boost.

JPMorgan’s Paul Meggyesi and his team believe that the greenback has everything to gain from both sides of the so-called “dollar smile” at the same time.

This “smile” describes the observation that the dollar tends to benefit from both extreme stress and strain to an extreme – when companies heavily borrowed in dollars around the world scramble for cash and cash. dollar liquidity – and rapid global growth and risk-taking – where US stocks outperform and US rates rise. Between the two, it’s at its weakest.

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“Our confidence has increased that the dollar is on the verge of a clearer breakout from either end of the dollar’s smile, or indeed both ends simultaneously,” the JPMorgan team wrote.

On the left side of the smile, they see growing angst that global growth has peaked, that political support is withdrawn, that global equities are overexploited, and that there are “growing global tail risks” from the crisis. China and related geopolitical fears.

On the right side are the Fed and “US rate-driven exceptionalism,” they say. Fed policymakers this week are likely to signal the start of U.S. interest rate hikes from late next year and – most importantly – up to six hikes through the end of 2024.

REAL TIME

Support for dollar interest rates is sometimes overlooked by focusing in isolation on nominal U.S. bond yields, especially in a year like this, when the dollar has remained firm even as U.S. Treasury yields have remained firm. declined during the summer.

A better measure of dollar fortunes is often seen in relative, or inflation-adjusted, real bond yields between the United States and other major economies or regions.

After spending most of 2021 in negative territory, for example, the US-Germany two-year real yield spread turned positive last month, and this week the new premium on US rates reached its highest level since June 2020. Ten-year equivalent US rate premiums are also their highest since April.

This view of the real rate makes sense for those who see inflation expectations and growth potential dominating a currency’s fortunes.

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All else being equal, tighter monetary policy today means lower inflation expectations, less erosion in the value of money over time, and a higher exchange rate – all assuming that the Growth potential is robust enough to support high rates and a higher “end rate” in the tightening. cycle.

And that has to be compared to expectations of growth and inflation in Europe or Japan.

Matthew Hornbach and his team at Morgan Stanley are also seeing the dollar rise further due to rising real rates. And they think this week’s Fed meeting could be a big time.

“The September FOMC could be a key catalyst pushing up US (real) yields, which we hope will give the dollar a big boost,” they wrote this week.

(by Mike Dolan, Twitter: @reutersMikeD; edited by Kevin Liffey)

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