DowExperts

BULLISH reversal in play for the US Dollar!

Long
TVC:DXY   U.S. Dollar Currency Index

Following the 2008 Financial Crisis, the Federal Reserve had to apply loose monetary policy measures in order to stabilize and stimulate the economy. The Fed started lowering the Federal Funds Rate back in late 2007, as a response to the rising unemployment at the time. This is the most traditional monetary policy measure, which aims to stimulate both businesses and individuals to borrow and spend more, which in turn would lead to an increase in economic activity. When rates are low borrowing money to start a business, buy a house or a car looks much more appealing and attractive. When the economy is in a recession such monetary policy actions are helpful and needed, but if interest rates stay very low for way too long after the economy stabilizes, then the higher spending levels caused by the cheap available credit would simply lead to higher inflation . Inflation has been one of the most heavily discussed subjects so far in 2021 and rightfully so. You see, a substantial increase in inflation is a net negative for all of the major markets out there – Bonds, Stocks, USD

Bonds

Inflation is a bond’s worst enemy as basically a bond is a contractual agreement between a borrower (Seller of the bond) and a lender guaranteeing that the Lender (Buyer of the bond) would be receiving the bond’s Face Value at maturity plus all of the regular and fixed interest payments (coupons) up until that point. Well, considering that both the Face Value and Coupon are fixed US Dollar amounts, a higher inflation would basically erode the real returns of that bond. To put it in simple words if the yield on a 10-year Treasury bill is 2%, that means that the investor is guaranteed to get a 2% annual return on that bond investment. However, if annual inflation is at 5%, then that makes the bond investment much less appealing as an investor would be technically losing 3% per year in such environment. This is the main reason why bond yields constantly adjust to both Inflation and Interest Rate expectations. When Inflation goes up, Interest Rate expectations start shifting towards expecting a rate hike, which leads to lower bond prices and higher bond yields. This dynamic exists and occurs as in an inflationary environment bonds become less attractive and in order for demand to come back to the bond market investors need to see an adjustment in the bond yields (an increase), which will protect them against inflation and would make it worthwhile for investors to lend their money to the US government by buying these bonds instead of putting it in a savings account with the bank. The bond yields rise either when we see a rate hike or when investors expectations of a rate hike increase. This mechanic ends up protecting bond investors in a higher-interest and inflation driven environment and makes bonds more stable and attractive investment vehicles than stocks.

Stocks

With stocks it is much more straightforward. Stocks trade largely on current as well as discounted future corporate profits, and higher rates tend to cut into profits because they increase the cost of money. Additionally, when rates are higher that means that discounting future cash flows to the present occurs with a higher denominator, which leads to lower profitability. If the underlying reason for higher rates is inflation , rising prices and wages also increase a company's costs, which further erodes profits. As you can see higher inflation and higher rates lead to plenty of problems for stocks.

USD

Last but not least, inflation is also bad for the US Dollar as it erodes the purchasing power of every dollar in circulation. To put it in simple words, if you have $100,000 in your savings account earning 1% interest annually, but the inflation in the country sits at 3% you would technically lose 2% from the purchasing power of your capital, or in other words $2,000, in just 1 year.

Now, after seeing why and how higher rates and higher inflation affect Bonds, Stocks and the US Dollar , you probably understand why all journalists, economists, investors, hedge fund managers, politicians, central bankers etc. are constantly discussing these topics. Inflation and Interest rates expectations are not static but rather very dynamic and are constantly modified and affected by economic reports, central bank commentary, monetary and fiscal stimulus etc.


The predominant view in the market at the moment is comprised of the following elements:

1.”The US economy is on fire” – companies continue to deliver better than expected earnings , consumers are sitting on record levels of savings, people are eager to get back to their normal lives eating out, traveling, shopping.

2. “We will see 8-10% GDP growth in the 2nd half of the year”

3. “Inflation will continue to rise as a result of the low interest rate environment and the huge spending driven mostly by the heavy Fiscal Stimulus by the US Government.

4. “The Fed need to raise rates sooner in order to prevent a hyperinflation scenario”

5. “The Fed will most likely end up being behind the curve once they start tapering, which will force them to rise interest rates quicker”

Now, while all of the above-listed arguments make sense to a certain extent, we believe that some of the most recent movements in the US Dollar Index ( DXY ) as well as the price action in the bond market, which sent bond yields lower despite the hawkish Fed in mid-June are giving us very valuable indications that there is more to that equation.

We believe that the whole narrative that is circulating at the moment starts from the wrong place. Considering the fact that the US Dollar is the global reserve currency and that it has a direct impact on both US and Global inflation levels and GDP growth, every US economic analysis should start from analyzing the US Dollar performance and its possible future trends. It is true that inflation expectations affect the value of the dollar and that some people might argue that this is a “what’s first the chicken or the egg” argument, but the US Dollar is so much more than the inflation expectations that people throw at it left and right. The USD is the most influential currency in the world and depending on whether it gets stronger or weaker we see whole countries, regions and even continents either struggling or prospering. The US Dollar index ( DXY ) has been in a clear downtrend throughout the last 15 months, as a result of the unprecedented printing of money that we have witnessed by the Fed in response to the COVID-19 pandemic shock to the economy. The monetary M2 supply in the US increased from $15.5 trillion in February, 2020 to $18.84 trillion in October, 2020 and to $20.1 trillion in April, 2021. This represents a 21.29% increase in 2020 and a 29.7% increase year over year. Technically, such a massive printing of liquidity debases and devalues the underlying currency. As a result of that and the increased inflation speculations and worries among investors we have seen the US Dollar index dropping from $103 down to the $90 level. A lot of negativity has already been priced in the US Dollar as the logic shows that inflation will definitely be picking up, which makes it unattractive to hold significant cash reserves. Thus, everybody has been selling the USD for over a year now. However, what happened in the beginning of the year (January) was that the DXY reached the $90 strong multi-year support and found a lot of buying interest there. After a strong rebound up towards the $94 level back in April, the index came back and re-tested the $90 level and once again found a lot of buying interest, which pushed the price back up to the $92 mark in a matter of few trading sessions. This has created a clear double-bottom pattern with rising relative strength and a clear bullish interest at these levels.

We believe that this is something that not many people are paying attention to as they are riding on the bandwagon that the “Dollar is going lower”. However the $90 support has been a crucial level for the DXY going all the way back to 1990s. Back in 2018 that was the exact level where the DXY stopped declining and reversed the 1.5 year long bear market that the USD was trading within since the start of 2017.

The reason why we believe that the way the USD moves is so crucial at the moment comes from the fact that the main argument right now for a tighter monetary policy is associated with the “double-digit” GDP growth that everybody expects in the 2nd half of the year and the inflation that this is expected to create in the economy. Well, it seems that most people have forgotten that currency appreciation usually reduces inflation because imports become cheaper and the lower prices lead to lower inflation . It also makes imports more attractive, causing the demand for local products to fall. Local companies usually have to cut costs and increase productivity so they can remain competitive. Furthermore, that means that with the higher price, the number of U.S. goods being exported will likely drop. This eventually leads to a reduction in gross domestic product (GDP), which is definitely not a benefit. That translates to a benefit of lower prices, leading to lower overall inflation .

The bond market also signaled that it does not expect the Fed to start tightening any time soon as there was a clear discrepancy between the hawkish Fed and the movement in the 10Y Treasury yields. You see, usually when an Interest Rate hike takes place or when Interest Rate expectations shift towards an increase in the Federal Funds rate, that is considered as bullish for bond yields. The reason for that as we pointed out earlier is associated with the fact that a rising interest rate environment and a potential for higher inflation makes bonds less attractive at the current extremely low yields. Bond yields then go up in order to bring back investors to the Bond market. Well, that has not happened this time around as even though we had a surprisingly hawkish Fed in mid-June, the 10Y Treasury yield has continued to fall. It seems that the 40-year long bull market for bonds has further to go. The Bond market always gives indications as to what is actually happening in the economy but very few people know how to read the correlations and information properly.

The most recent price action in the 10Y Treasury yield shows that the real probability of the Fed tightening sooner than expected is much lower than what the equity markets and all other market participants are currently pricing in. Bond investors tend to have more macro-oriented view, which allows them to see the big picture better.

So what does that mean?

Well, with the US Dollar threatening to reverse its 1-2 year downtrend and break above the critical resistance sitting at 92-93 and Bond yields falling, the economy and inflation growth will be tamed organically by the higher dollar. We believe that this would lead to the Federal Reserve also pushing back its tightening program, which in turn will reignite risk-appetite in the market. Thus, we expect to see Growth outperforming Value in the coming months.