Global Investment Strategy team
Cross Asset Strategy
Equity volatility has notably cooled over recent weeks. The VIX Index, which measures implied volatility of US equities, is at lows not seen since the end of summer. The S&P 500 is now up over 10% from early October lows, breaching the 4,000 mark for the first time in two months. Meanwhile, bonds remained volatile – the short-term treasury yields are still approaching cycle highs as longer-term yields have fallen from their peak. The MOVE Index, which measures implied rates volatility, persists at historically elevated levels.
The recent optimism in risk assets can be attributed to a number of factors. Signs from both U.S. CPI and PPI that inflation might be peaking, as well as hints from the FOMC minutes that the Fed may execute a slower pace of rate hikes from here, both suggest that we may be approaching the end of the policy tightening cycle. A rate hike step down from 75bps to 50bps in December is now widely expected by the market. Upside surprises to earnings reports and healthy consumption data also helped the risk sentiment.
On the FX front, we’ve now seen the largest 10-day selloff in the USD going back to 2000 – aside from a brief period in the extreme volatility of 2008-2009. Historically, when the dollar valuation screens as rich as it was in early November, the dollar typically falls about 6-7% over the next 12-months, on average. In other words, we just got the mean reversion we typically get in a year in two weeks. Is the turn in the dollar already here? Read on for our view.
Strategy Question: Is the U.S. dollar finally turning?
Before the recent weakness, the dollar had been having its best year since the 1970s. This matters for investors; currency exposure could generate substantial outperformance or underperformance, depending on which way it swings, and multinational corporate earnings are likewise impacted.
Over recent weeks the USD has been beginning to screen expensive across all of the valuation frameworks we employ – historical averages, rate differentials, global growth dynamics. Historically, the dollar would weaken from such stretched valuation levels within a 12-month horizon. Against that backdrop, our view on the broad USD has been that Dollar strength will likely recede over the medium-term. However, that “mean reversion” process would require some catalysts to really begin.
To get a sense of how the U.S. dollar might move, we often rely on the “smile” framework, which holds that the greenback typically strengthens when:
- The global economy is weak and investor risk appetite turns negative (the left-hand side)
- When the U.S. economy outperforms the rest of the world and focus turns to Fed rate hikes (the right-hand side)
On the other hand, the dollar tends to weaken once the Fed pivots back towards more accommodative policy, and the rest of the world grows in tandem.
That framework has held true this year — the dollar has been very strong against the backdrop of US economic outperformance and higher USD interest rates. From here, to see the dollar turn we need to see:
- Evidence that inflation is cooling in the U.S., which gives the Fed room to pause from its ultra-hawkish stance
- Global growth expectations stabilize, and ideally, improve (particularly from China and Europe)
Over the past weeks, we’ve seen progress on both fronts. The softer-than-expected U.S. CPI report was a clear start. While one or two data points do not make a trend, it helps to make the case for the Fed to step down its pace of rate hikes, it signals that the end of the hiking cycle is getting closer rather than farther away, and it removes some degree of uncertainty regarding the trajectory of U.S. rates. In other words, U.S. rate vol – one of the key forces supporting the USD this year – could be peaking. On economic growth, tail risks in Europe have diminished in the near-term with the fall in natural gas prices from their peak.
That said, macro uncertainty is still high and recession risks remain elevated, particularly outside of the U.S. Therefore, we aren’t yet waving the flag for the dollar’s turn—but we are paying close attention. That continues to leave us with a preference for U.S. over international assets.
For investors, it’s a dimmer-dial, not an on-off switch
While we think we are still a bit of a way away from a genuine turn in the dollar, the two catalysts for dollar weakness (stabilizing inflation and global growth) are likely not too far on the horizon. With that in mind, it may make sense to take profits on some investments that have benefitted from this year’s historical rally in the greenback.
Positioning for a turn in the dollar generally happens in two stages: First, currencies and precious metals that tend to provide lower growth and yield (like the Japanese yen and Swiss franc, and gold) tend to recover. And later, when there are full-on early cycle dynamics, higher-growth-oriented currencies (like emerging markets) rally. We think investors should start thinking about that first stage. But remember, investing through cycles is about using dimmers and dials as the environment shifts. It’s not ideal for your portfolio to have an on-off switch.
Over the longer term, a strategic allocation decision across global asset markets today should also carefully consider the impact of currency movements, as it will be a meaningful component of future returns. USD-based investors, in particular, could be positioned to reap the tailwinds from ex-U.S. exposure as the dollar reverts to more average valuation metrics.
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Index definition:
The Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.
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.
The CBOE Volatility Index (VIX) is a benchmark index to measure the market’s expectation of future volatility, based on options of the S&P 500 Index.
The ICE BofA MOVE Index (MOVE) is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30 (weighted average of 1m2y, 1m5y, 1m10y and 1m30y Treasury implied vols with weights 0.2/0.2/0.4/0.2, respectively).
