Macro Wrap – Seismic Shift in the U.S. Dollar

by Enis May 15, 2013 6:53 am • Commentary

I mentioned in my wrap on Friday that the dollar was close to a long-term breakout.  I’m writing about the dollar again because I think we are close to a seismic shift.  After more than a decade of a generally weak U.S. dollar, I see many stars aligning for a renewed, long-term period of dollar strength.  Why now?

1.  Rates Have Converged to 0.  

If I’m a global investor looking for fixed income, I am close to running out of areas where I can earn 5% per year.  Since 2002, the short-term interest rate on the dollar has often been near 0, offering no yield, and pushing investors into other currencies.  While the yield on the dollar is still near 0 in the short end (and only 2% in 10 year space), other currencies’ yields have converged to near 0 in the past few years, offering few attractive alternatives.  Even farther out, here are the 10 year swap rates for other developed countries (compared to 2.1% in the U.S.):

  • Australia – 3.9%
  • Canada – 2.4%
  • Eurozone – 1.63%
  • Japan – 1.0%
  • Switzerland – 1.1%
  • U.K. – 2.02%

All of a sudden, 2.1% for the 10 year rate in the U.S. does not look exceptionally low.  Even for developing countries, 10 year rates have moved significantly lower in the past few years, and offer much less extra yield than in the past:

  • Brazil – around 10% 
  • India – 6.3%
  • Mexico – 5.35%
  • Russia – 7.41%
  • South Africa – 6.58%
  • Turkey – 7.44%

Those yields look ok, except when you consider the currency volatility in those countries, where 5% of extra yield can be wiped out in a week.  In developing Asia, some of the rate levels are even more mind boggling:

  • Malaysia – 3.66%
  • Philippines – 3%
  • South Korea – 1.8%
  • Thailand – 3.47%

Would you rather earn 3-4% with your money in Malaysia, the Philippines, or Thailand, or 2% with your money in the U.S.?  Would you rather earn 1.6% with your money in the Eurozone, or 2% in the U.S.?  Would you rather earn 1% with your money in Japan, or 2% in the U.S.?

All of a sudden, the U.S. dollar is not looking too shabby.

2.  The Federal Reserve’s next step is more likely to be taking the foot off the gas rather than pushing further down on the pedal.  

I don’t expect an end to QE anytime soon.  But neither does the rest of the market.  The default assumption seems to be that QE Infinity continues at its current pace for the rest of 2013, with potential adjustments in 2014.

I was on Turkish CNBC yesterday morning, and when I suggested that we might see some tapering of the program in the next 6 months, I was surprised at the reaction of the other guests, who both dismissed the possibility of any move to taper by the Fed until at least 2014.  But the Fed dropped its first hints last week, in both Bernanke’s speech and Hilsenrath’s WSJ article.  And Tim Duy had a good analysis of Plosser’s speech yesterday, which introduced a new argument for reducing purchases:

Indeed, in my view, were the FOMC to refrain from reducing the pace of its purchases in the face of this evidence of improving labor market conditions, it would undermine the credibility of the Committee’s statement that the pace of purchases will respond to economic conditions.

As Duy points out, that argument is likely to have more sway with other FOMC members than any comments about future inflation concerns.  In addition, the Fed is getting more concerned with financial stability as financial markets get more giddy.

But most importantly, the U.S. dollar has been able to rally this year even with the Fed in full QE mode.  In my mind, any hints at reducing QE by the Fed would just add rocket boosters to a trend that is already in force.

3.  Outperformance of U.S. assets.

The 2000-2010 period was defined by the growth of emerging markets, led by China, and a shift in asset allocation away from the developed world and into the developing world.  It led to increased investor exposures to emerging market stocks, commodities, and emerging market bonds and deposits.

In the past couple years, we have seen the pendulum swing back towards the developed world, as emerging market stocks and commodities have underperformed as investments.  That has significantly reduced the appeal of emerging market assets, and is leading to a shift back into growth investments in the U.S. (which is still the envy of the developed world in terms of financial market depth and performance).

I expect that trend to continue on a relative basis in the next 5 years, particularly since China’s overbuilding in the past 5 years will likely take years to work through.  That should continue the shift into U.S. dollar assets.


In sum, I am buying U.S. dollars vs. almost everything.  I think this trade is just beginning, and it’s my biggest single position in my trading accounts.  I am long FXE and FXA puts, and long UUP and UUP calls.  If we are on the cusp of a 10-20% move higher in the dollar over the next year, then currency volatility is much too cheap.