The Smiling Assassin (The Dollar Smile)

One of the complexities of the foreign exchange market is that the US dollar – as the global reserve currency – can rally in phases of risk aversion or strong growth. This is an effect known as the dollar smile. As we noted this time last year, the prevailing bias for 2021 was an extrapolation of US dollar weakness which is typical in a global expansion and positive liquidity environment. Of course, the low in the dollar this year occurred in the first week of January.

To be fair and as we often emphasize, currencies are complex. They are often used as a policy tool and can diverge from “fundamental” drivers such as growth, inflation, interest rates and external positions for an extended period of time. Currencies are always a relative price. Hence, the fundamentals need to be viewed in relative terms. For example, the higher-than-consensus October CPI data might be viewed as negative for the real value of the dollar. However, the dollar index is a combination of other major fiat currencies. Put another way, the dollar can rise with inflation, but purchasing power might be better viewed through the lens of commodities. Hence it is interesting that there has been a coincident recovery in spot gold during the recent phase of dollar strength.

Another complexity in the current phase is near-term growth, inflation and short rate expectations versus consensus beliefs on the terminal rate or where the policy rate might end up in this cycle. While a few current FOMC members have played down a shift in terminal rate expectations from around 2.5% (the current median on the dot plot) Bill Dudley, formerly of the New York Fed has suggested that the funds rate should end up at 3-4% in this cycle. A proxy for the market’s expectations of the terminal rate is the 16th Eurodollar contract. While that has moved up recently it remains below the FOMC’s terminal rate projection. It has probably also been a factor that has supported the recent impulsive move in the dollar. Although it is consistent with relative real rate differentials as well.

Tactically, it is plausible that short-rate expectations and beliefs on near term inflation risk and supply-side disruptions are now a widely held prevailing bias. On the negative side, monthly inflation data might not ease until at least the second quarter of 2022 especially with shelter and employment costs likely to rise further (the second wave). While demand for inflation protection appears increasingly crowded, it is possible that central banks might ramp up their hawkish tone. That might also continue to support the US dollar in the near term. At the very least, it probably warrants a faster move away from emergency policy (and financial) conditions which would be a challenge for long-duration assets and liquidity beneficiaries that still appear to be anchored around lower-for-longer rate expectations.

In conclusion, a rapid and impulsive rally in the dollar is something to monitor given the central role it plays in financial conditions and global liquidity. A rapid increase in the dollar can be trouble for entities that have borrowed in the reverse currency and as that often coincides with a higher discount rate and liquidity withdrawal. Conversely, a peak in rate and inflation expectations might ease dollar strength and support a renewed rally in EM and Asian assets.