Cross Asset Strategy
As expected, the Federal Reserve raised the policy rate by 25bps at its first policy meeting in 2023. Three points stood out to us – the Fed showed little concern about the recent loosening of financial conditions; Powell recognized that a disinflationary process is underway for the first time; and new economic forecasts will tell us more in March. These messages further signaled that the central bank is getting closer to the end of the tightening cycle. Markets reacted positively with higher stocks, lower treasury yields and a weaker dollar.
The development has been in line with our outlook. While Powell still warned about “ongoing increases” in the Fed Funds rate, it sounded like we could see a downgrade to the inflation forecast in March and likely a reduction of the terminal rate. We continue to believe that the Fed will likely start easing towards the end of this year. To express this view, we favor extending duration in fixed income portfolios and shorting the dollar, especially against the “low-yielders”.
Strategy Question: How do you trade USD weakness?
Massive moves in the FX market have been a major focus for investors of late. The Dollar Index (commonly referred to as the DXY index) has shed over 10% since its highs in late September, following a historic +27% rally in the last year and a half. As we mentioned in our 2023 Outlook, we expect dollar weakness to be one of the key themes of macro trades this year. So why is this the case? And how may investors play the theme now?
To understand why weakness in the U.S. dollar could be a sustained trend, it’s helpful to look at what happened in 2022. During 1H, the Fed started hiking aggressively – at a pace that hadn’t been seen in the past 40 years – in the face of a large inflation overshoot. USD rates shot up much quicker than other major currencies. A wider interest rate differential in favor of the U.S. drove a rally in the dollar. In 2H, other central banks started to catch up in terms of hiking rates, but the global growth environment was incredibly weak. In particular, China was going through rolling lockdowns. Europe was facing a potentially very deep energy crisis. Global equity market declines had also deepened. This drove another leg of dollar strength as investors sought a safe haven. The confluence of factors drove the dollar to highly overvalued levels – as much as 20% higher than its modeled fair value (based on 5-year interest rate differentials) at the peak.
What we’ve been seeing the last few months – and what we expect to continue into 2023 – is the erosion of all these pillars that pushed the dollar stronger in 2022. Interest rate expectations are peaking in the U.S. but still rising in the rest of the developed world. In other words, rate differentials have started to turn from a support for the dollar to a headwind. Looking ahead, USD rates will likely continue to “catch down” to other developed markets as U.S. inflation trends lower and the Fed reaches the end of its hiking cycle. Meanwhile, with inflation staying sticky in Europe and picking up in Japan, policy directions of these central banks are more likely to tilt towards the hawkish side. From an asset allocation standpoint, with the disappearance of negative yielding debt in Europe and Japan – and U.S. equities perhaps no longer outperforming global indices – we could start to see a rebalancing of U.S. asset overweights in global portfolios.
Global growth dynamics, the second pillar of dollar strength in 2022, are also shifting. The reopening in China has been faster than expected. In Europe, this winter has turned out to be less cold than had been feared, and natural gas prices have fallen 70% from the peak. Increasingly, the U.S. is looking less exceptional from a growth perspective.
Add in the fact that the U.S. dollar still screens 10% overvalued, and we see some further weakness ahead.
How to trade USD weakness?
Positioning for a weaker dollar generally happens in two stages: First, currencies and precious metals that tend to provide lower growth and yield (like the Euro, Japanese yen, Swiss franc, and gold, aka the “low yielders”) tend to strengthen. And later, when the global economy demonstrates full-on early cycle dynamics, higher-growth-oriented currencies (like commodity FX and emerging markets, aka the “high beta”) will likely join the rally in a more sustained way. We are currently in the first stage. Here are a few ways that we favor participating in this trade:
1. The Euro
The Euro recently rebounded from sub-parity against the dollar to levels seen before the Ukraine crisis. The worst fears for the winter period have not played out, and we have seen large declines in natural gas prices. We still see upside in the Euro from here in the near term. The market is pricing the European Central Bank to hike rates above 3.25% this year. This shift in interest rate differentials is consistent with fair value for EURUSD above 1.15. However, we’d note that energy prices will need to remain benign for us to really see the shift towards fair value. Otherwise, some Europe-specific risk premium will likely stay.
2. The Japanese yen
Moves in USDJPY are closely correlated with interest rate differentials. Over the past two years, changes in the spread between 10-year U.S. treasury yields and 10-year JGB yields explain 80-90% of the moves in USDJPY. Over the recent months, traders started to bet on higher JPY rates (as shown by the spikes in the swap rate), especially after the surprise announcement by the BOJ to widen the yield curve control (YCC) band in late December. While the BOJ meeting in January underwhelmed the market by leaving all monetary policy settings unchanged, the longer-term trajectory is still highly JPY supportive, in our view. The currency remains undervalued especially given that rate differentials look poised to continue to narrow. Core inflation in Japan recently rose to almost two times the BOJ target, and with wage inflation rising, the composition of inflation pressure has shifted from mostly imported to more home-grown, which is a sign of stickier inflation from here. Eventually the central bank would have to think about further normalization in monetary policies.
While the functionality of gold as an inflation hedge is being increasingly questioned, the yellow metal could shine again this year. Historically, gold prices usually gain support from a weaker dollar and lower real yields. With yields peaking in the U.S., the trough in gold could be behind us, with the metal joining the rally of the low yielders. We favor gold not only as a way to participate in the weaker dollar trend, but also from a portfolio diversification standpoint.
Does RMB fit in this trade?
The RMB is getting strong support from improved sentiment thanks to the rapid reopening in China and continued inflows as global portfolios close their large underweights in Chinese assets. Coupled with broad weakness in the dollar, USDCNH declined from a high of above 7.3 to 6.7 levels. However, long CNH is still not how we would express the China re-opening theme (we would rather focus on equities and credits, as discussed in a recent article). Negative carry and risks of further deterioration in the balance of payments as we move through the year suggest that not all CNH-negative factors are neutralized. As the slowdown in goods demand from U.S. and European consumers continues, China’s exports will likely deteriorate from high teens growth over the past two years to a significant contraction this year. At the same time, outflows could see a boost if outbound tourism resumes. Given these factors and how fast CNH has moved, we don’t favor it as a way to trade dollar weakness from here. For dollar-based investors looking to add exposure to CNY-denominated assets, one strategy would be to hedge out FX risks and lock in a positive carry.
All market and economic data as of February 2, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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The U.S. Dollar Index (DXY) is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies.