If dollar breaks down, it could open 10-yr opportunity in EM
First of all, I want to acknowledge that I am indebted for this idea to Raoul Pal and the fine folks at Global Macro Investor and Real Vision Group. I personally know just enough about finance to be dangerous, but these guys know their stuff and I stand on their shoulders, especially in relation to Forex.
The U.S. dollar index is now *very* close to a key breakdown of its 10-year uptrend, as shown on the chart. This is driven not only by the Fed's talk of "overshooting" its 2% inflation target this year, but also by the expectation of massive deficit spending by Congress and the possibility that US policymakers will maintain a loose monetary policy for years to come.
If the dollar does break its 10-year uptrend, it could open up a huge opportunity to invest in emerging markets. Emerging markets are strongly inversely correlated with the dollar, so the dollar's strength over the last 10 years has caused emerging markets to underperform vs. the S&P 500. A long-term reversal in the dollar would change that.
However, a couple caveats here. First, a lot of FX wonks use the trade-weighted dollar index, in which there's quite a bit further to go till we hit the trendline. In short, temporary changes in trade balance due to the pandemic may be making the dollar index look weaker than it actually is. In trade-weighted terms, the dollar is simply normalizing after a huge spike.
My second caveat is that although Donald Trump has been a president of extraordinarily loose monetary policy-- of Modern Monetary Theory even-- Joe Biden has shown signs of being a tight-money guy. It sounds strange to say that Democrats might be the fiscally conservative party this round, but that's the strange reality we live in. Biden's plan to raise corporate tax rates is essentially a tight-money policy that would remove dollars from circulation. So a Democratic sweep in the next election might conceivably cause a return to dollar strength.
Trump also recently appointed a gold-standard proponent to Fed Board of Governors, in a sign either that he has no consistent views on monetary policy, or that his views might be growing more conservative. Two more signs that the current administration may be growing more conservative on this are that Treasury Secretary Mnuchin said today that "We want a stable dollar," and that the Republican stimulus proposal is only $1 trillion rather than the $2 - 3.5 trillion that some have predicted. Plus, if the stimulus excludes relief for state and local governments (as in the Republican plan), then monetary tightening will be inevitable because state and local governments will have to raise taxes to make up for revenue shortfalls this year. (Again, taxes are a tight-money policy because they remove dollars from circulation.)
So while forex traders seem broadly bearish on the dollar as it approaches this trend line, I'm personally less certain that we'll see a breakdown. On this side of the trend line, I think it still makes sense to be long US dollars and US equities. But should we get a trend line break, I'm prepared to start rebalancing to include some emerging markets in my portfolio mix.
The U.S. dollar index is now *very* close to a key breakdown of its 10-year uptrend, as shown on the chart. This is driven not only by the Fed's talk of "overshooting" its 2% inflation target this year, but also by the expectation of massive deficit spending by Congress and the possibility that US policymakers will maintain a loose monetary policy for years to come.
If the dollar does break its 10-year uptrend, it could open up a huge opportunity to invest in emerging markets. Emerging markets are strongly inversely correlated with the dollar, so the dollar's strength over the last 10 years has caused emerging markets to underperform vs. the S&P 500. A long-term reversal in the dollar would change that.
However, a couple caveats here. First, a lot of FX wonks use the trade-weighted dollar index, in which there's quite a bit further to go till we hit the trendline. In short, temporary changes in trade balance due to the pandemic may be making the dollar index look weaker than it actually is. In trade-weighted terms, the dollar is simply normalizing after a huge spike.
My second caveat is that although Donald Trump has been a president of extraordinarily loose monetary policy-- of Modern Monetary Theory even-- Joe Biden has shown signs of being a tight-money guy. It sounds strange to say that Democrats might be the fiscally conservative party this round, but that's the strange reality we live in. Biden's plan to raise corporate tax rates is essentially a tight-money policy that would remove dollars from circulation. So a Democratic sweep in the next election might conceivably cause a return to dollar strength.
Trump also recently appointed a gold-standard proponent to Fed Board of Governors, in a sign either that he has no consistent views on monetary policy, or that his views might be growing more conservative. Two more signs that the current administration may be growing more conservative on this are that Treasury Secretary Mnuchin said today that "We want a stable dollar," and that the Republican stimulus proposal is only $1 trillion rather than the $2 - 3.5 trillion that some have predicted. Plus, if the stimulus excludes relief for state and local governments (as in the Republican plan), then monetary tightening will be inevitable because state and local governments will have to raise taxes to make up for revenue shortfalls this year. (Again, taxes are a tight-money policy because they remove dollars from circulation.)
So while forex traders seem broadly bearish on the dollar as it approaches this trend line, I'm personally less certain that we'll see a breakdown. On this side of the trend line, I think it still makes sense to be long US dollars and US equities. But should we get a trend line break, I'm prepared to start rebalancing to include some emerging markets in my portfolio mix.
Comment:
We fell sharply through the trend line today, and precious metals and emerging markets are rallying accordingly.
