January 18, 2021

Dollar – Diversification, rotation and valuations

BY Olivier Desbarres

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Media and analyst reports focussing on the scope for further US Dollar weakness and Emerging Market currency outperformance have continued to proliferate in the past month.

The consensus view is still seemingly that a Democratic administration will fuel large US twin deficits and expectations of higher domestics inflation while Fed will keep rates on hold, eroding the value of Dollar assets. At the same time a pick-up in global confidence, economic growth and risk appetite will benefit EM and commodity currencies.

While the “safe-haven” Dollar weakened sharply and EM currencies outperformed in the wake of the US elections on 3rd November recent facts tell a different story. Since 10th December the Dollar Nominal Effective Exchange Rate (NEER) and GDP-weighted baskets of developed and EM currencies have been broadly flat according to our calculations.

Central European and Latin American currencies, which outperformed in November, have underperformed in past five weeks. Emerging Asian currencies, including the Chinese Renminbi, have done little since 10th December pointing to still active central bank FX management. This price action has broadly tallied with our near-term view that EM currencies will be “prone to sharp sell-offs (even if short-lived)”.

Our analysis suggests that the steepness of the US Treasury yield curve rather than inter-country yield spreads matters more for the Dollar.

However, we think central banks and sovereign wealth funds’ diversification out of Dollars into other reserve currencies, including Euro, Sterling, and Canadian, Australian and Kiwi Dollars, between May and early December was the main driver of Dollar depreciation.

Dollar NEER’s stability since 10th despite a further 2.7% gain in the S&P 500 suggests this diversification process has stalled, which we think is partly due to stretched valuations. At the same time price action points to a rotation out of the Euro into Sterling.

We stick with our view that Dollar depreciation may not resume for another couple of months and will in any case not be as broad based as in November/early-December with markets paying greater attention to domestic factors, including valuations.


Separating fact from fiction: Dollar resilience and tepid EM currency performance

Media and analyst reports focussing on the scope for further US Dollar weakness and Emerging Market (EM) currency outperformance have continued to proliferate in the past month. In two recent articles the Financial Times referred to the 7% fall in the US Dollar DXY index in 2020. On 4th January 2021 the Financial Times noted that the MSCI Emerging Markets Currencies Index had reached an all-time high and that the USD/CNY cross had traded below 6.50 for the first time since June 2018. On 8th January the Financial Times flagged that the US Dollar DXY index had “touched its weakest levels since April 2018”. It went on to quote a number of analysts forecasting that:

  • The Democrats regaining control of the Senate would bolster market expectations of looser US fiscal policy (and material twin deficits) and higher domestic inflation due to the Federal Reserve’s asymmetric inflation target.
  • Alongside a Federal Reserve reluctant to hike its policy rate as fast as some other central banks this would erode the value of Dollar assets.
  • Emboldened investors would thus look beyond typical safe havens like the Dollar and “seek out riskier corners of the market”, including EM and commodity currencies, which would also benefit from a pick-up in global confidence (thanks in part to worldwide roll-out of Covid-19 vaccine), economic growth (with the pick-up in Asia already visible) and risk appetite


On paper the arguments underpinning these forecasts for the Dollar, commodity and EM currencies hold some water. However, before turning to the future and our own predictions for these currencies, let us first look at the recent facts.

  • The Dollar Nominal Effective Exchange Rate (NEER) – a (Federal Reserve) trade-weighted average of the Dollar versus the currencies of the United States’ main trading partners – has appreciated about 0.2% since 10th December, according to our calculations (see Figures 1-3). The narrower and arguably less relevant Dollar DXY index – a weighted average of the Dollar against the Euro, Japanese Yen, Sterling, Canadian Dollar, Swedish Krona and Swiss Franc – has appreciated by a similar magnitude in the past five weeks[1]. Actually the Dollar NEER and DXY index have traded in very narrow ranges of just 1.3% and 1.8% respectively. So much for sustained Dollar weakness…In comparison in the previous five weeks (the period after the US elections on 3rd November) the Dollar NEER and DXY index weakened by respectively 3.1% and 2.8%.


Dollar – Diversification, rotation and valuations 1


  • A GDP-weighted basket of EM currencies has been broadly flat versus the US Dollar since 10th December, despite the Renminbi (which accounts for 44% of our EM currency basket) appreciating about 0.8% (see Figures 2-4). The Turkish Lira (+5.1%) is the only EM currency to have appreciated by more than 1% versus the Dollar (see Figure 4). Again this flies in the face of the slew of media reports pointing to the outperformance of EM currencies
  • The regional currency blocks which outperformed in the five weeks following the US election on 3rd November – Central Europe and Latin America – have underperformed the most since 10th December (see Figures 2 & 3).
  • Emerging Asian currencies (excluding the Renminbi) which underperformed between 3rd November and 10th December (+2.2% versus the Dollar) have flat-lined since then. The more prosaic performance of Asian currencies on the whole suggests that Asian central banks have been pro-actively managing their currencies, including via FX intervention, in a bid to cap volatility and maintain an “optimal” level for their currencies in terms of promoting export competitiveness while moderating deflationary pressures.


Dollar – Diversification, rotation and valuations 2


  • Notably, despite its recent dip a GDP-weighted basket of developed market currencies has been broadly flat versus the Dollar since 10th December and slightly outperformed a GDP-weighted basket of EM currencies excluding the Renminbi (-0.9%), according to our calculations (see Figure 3). The weakest developed market currencies since 10th December have been the Euro and Swiss Franc which have each only depreciated about 0.6% versus the Dollar.


Dollar – Diversification, rotation and valuations 3


This price action broadly tallies with our view that:

  • Near-term EM currencies will be “prone to sharp sell-offs (even if short-lived)” as “national lockdowns will likely continue to weigh on already very weak global GDP growth […] Delays to mass Covid-19 vaccination will puncture governments’ ambitious expectations (and promises) and poorer, populous EM economies will lag richer nations in terms of distributing the vaccine to a significant share of their populations” (see Emerging Market currencies: Hopes and Realities, 2nd December 2020); and


However, any currency prediction for the next few months (let alone year) needs to be underpinned by a broad understanding of why the Dollar’s resilience and tepid EM currency performance have confounded markets in recent weeks.


Dollar – Diversification, rotation and valuations 4


Treasury yield curve steepness rather than inter-country yield spreads matters for Dollar

A common view in recent months has been that nominal yield spreads would work against the Dollar, specifically that US interest rates would rise more slowly than interest rates in other major economies and thus deprive the Dollar of “carry”. However, it is not obvious to us that nominal yield spreads have been the main driver of the Dollar’s performance. For example, the spread between 2-year US Treasuries and German Bunds has oscillated in a narrow range of 78-99bps since the collapse in global risk-appetite in late-March and yet the Euro has appreciated about 11% versus the Dollar (see Figure 5). The flows which have appreciated the Euro have clearly been attracted by factors other than the Euro’s relative yield advantage over the Dollar.


Dollar – Diversification, rotation and valuations 5


Another, more plausible explanation in our view is that it is the relative steepness of the US Treasury curve which matters for the Dollar. Specifically the consensus view has seemingly been that a Joe Biden presidency and Democrat-controlled Congress will result in ultimately loose fiscal policy (at least looser than under a Trump presidency and Republican-controlled Senate). This will in turn lead to higher US inflation but no corresponding increase in the Federal Reserve policy rate and short-term government bond yields, at least in the near-term. Indeed US 2-year Treasury yields have stagnated between 1bp and 19bp since mid-year (see Figure 6). This ultimately devalues the real value of US assets, including the Dollar.


Dollar – Diversification, rotation and valuations 6


However, markets start pricing in Federal Reserve policy rate hikes further down the line, causing 5-year Treasury yields to rise and the 2s-5s curve to steepen. The relative steepness of the US Treasury curve, including its steepening since late-September from about 13bp to 32bp currently, has indeed tended to inversely correlate with the Dollar NEER (see Figure 7).


Dollar – Diversification, rotation and valuations 7


Reserve diversification likely key driver of Dollar’s relative performance

A third and related explanation, and ultimately the most compelling in our view, for the Dollar’s demise between May and early December is that low interest rates worldwide fuelled global equities (including the S&P 500) and the attractiveness of more risky assets (including EM currencies). This in turn contributed to central banks and Sovereign Wealth Funds in particular diversifying their FX holdings out of “safe-haven” Dollars into other major reserve currencies such as the Euro, Sterling and the Canadian, Australian and New Zealand Dollars (and more minor reserve currencies such as the Norwegian Krone) while shunning other safe-havens such as the Swiss Franc and Japanese Yen (see Figure 4). This inverse relationship between global risk appetite (as measured by the S&P 500) and the Dollar NEER was indeed robust between February and early December (see Figure 8).


Dollar – Diversification, rotation and valuations 8


In the past five weeks the Dollar NEER has been broadly stable despite the S&P 500 rising a further 2.7% which we attribute in part to the currency reserve diversification process having to a large extent ground to a halt (see Figures 3 & 8). In particular since 26th December we estimate that the Dollar NEER moved in the same direction as the S&P 500 in seven out of fourteen trading sessions (see green boxes in Figure 9).

Central banks and SWFs may have put on hold (for now at least) this currency diversification process for a number of reasons, including stretched valuations – i.e. exchange rate levels. Put differently the view that the Dollar was once again attractive (or at least not particularly unattractive) may have gained some ground amongst at least some subsets of market participants, in our view. After all five weeks ago the Dollar NEER was at its weakest level since early February 2020 while the DXY index was at its weakest level since April 2018 according to our estimates (see Figure 1).

There has also been some rotation between other reserve currencies, in our view, including a move out of Euros and corresponding move into Sterling. The GBP/EUR cross rallied a further 1.3% last week, at one point on 14th January trading as high as 1.1272 (its strongest level since 11th November. We partly attribute this uptrend to the relative pace of vaccination in the United Kingdom and the Eurozone, with the UK maintaining a healthy lead over its European counterparts. For example the UK has to date given a first dose of the Covid-19 vaccine to about 3.8 million people versus only 100,000 in France. The GBP/EUR cross did dip slightly on Friday after data showed that UK GDP had contracted 2.6% mom in November and has since weakened further to 1.124 at time of writing.


Dollar – Diversification, rotation and valuations 9


The bigger question now is of course whether diversification out of Dollars (into more risky assets such as EM currencies) will remain on hold for the foreseeable future, resume or actually reverse and see the Dollar appreciate. As noted above we are for now sticking with our view that Dollar depreciation may not resume for another couple of months, until it becomes clearer that a matrix of loose US fiscal policy but still low US interest rates will likely dent the Dollar’s attractiveness. At the same time we think the slow start of the vaccination process in many major developed and EM economies could delay a rebound in global confidence and GDP growth and in turn act as a brake for EM currencies as a whole. As we highlighted in Biden’s trump cards and challenges (12th January 2021) GDP growth slowed sharply in Q4 and the omen for January have so far not been good.

In any case we think that any resumption in Dollar depreciation is unlikely to be as a broad-based as it was in November and early-December when all 31 major currencies we track appreciated versus the Dollar (see Figure 4). Put differently, we think that markets will pay greater attention to domestic factors, including valuations and potentially monthly seasonal patterns, when picking their winners and losers in the currency space (see Monthly currency seasonality: Down and out?, 4th January 2021). We will explore this theme in greater detail in forthcoming Fixed Income Research & Macro Strategy reports.


[1] The weights attributed to these Dollar exchange rates are respectively 57.6%, 13.6%, 11.9%, 9.1%, 4.2% and 3.6%. For starters these currency weights do not match up with these countries’ shares of the United State’s external trade, which are 19% for the Eurozone, 6.3% for Japan, 5.3% for the United Kingdom, 13.4% for Canada, 0.5% for Sweden and 2.6% for Switzerland according to the Federal Reserve. Moreover, these weights in aggregate account for only 47% of the United States’ total external trade (for example the Chinese Renminbi is excluded for the DXY index despite China accounting for nearly 16% of US trade). The Dollar NEER is thus arguably a more comprehensive measure of the Dollar’s competitiveness and its potential inflationary/disinflationary impact, in our view.

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