This is an update of our article published at Seeking Alpha on June 18, 2018, “U.S. Dollar: Forget Monetary Policy Divergence; Firming U.S. Capital Account Supports DXY Until 2019.“
We said then:
The sharp improvement in US capital account since Q3 2016 therefore results in further rise of the US dollar until late June this year, then a decline until July-August followed by a rising US currency until the first half of 2019.
That forecast happened in a general way, with the US dollar bull phase extending up to late March, this year, when global risk asset markets started to recover from its COVID-19 fright and the US currency lost its cachet as safe haven destination of global capital.
Since then, the US Dollar Trade Weighted Index has been weak against a bevy of Developed Market (DM) currencies. It has been weakest against the euro during that time, but also had significant losses versus the Swiss franc and JPY. It was no wonder, therefore, that DXY (USD vs. DM currencies) fell much further than the USD NEER Nominal Index did (see chart below).
This episode of US dollar weakness is about to come to an end – if it had not done so already. The fundamentals that matter for the US currency have turned around. Given the prospects of better-than-expected GDP growth in Q3 and further prospects of rising yields (as the Fed does a volte-face on its inflation paradigm), the US currency is on the verge of a massive revaluation higher.
Moreover, shorting the US dollar has become a one-way bet, and therefore, this short trade is going to unwind quickly when the market senses the inflection point taking place. The US dollar is a trade that is screaming to be bought.
We discussed the macro-economic prime movers of the US currency in our June 18, 2018, Seeking Alpha article. It is, therefore, worthwhile re-reading it, as the piece provides more detailed information on some of the factors that we are discussing in this current article.
The US Capital Account is a powerful prime mover of the US Dollar
In a broad macro sense, changes in the US dollar valuation stem from shifts in broad international, systemic liquidity flows among countries and economic regions. These shifts in the transfer of money and investment capital are tallied in a country’s current and capital accounts, and for this purpose, the capital account is the primary data that we track.
The capital account balance reflects net change in ownership of national assets and is one of the components of a country’s Balance of Payments ledger (the other being the Current Account Balance). A surplus (or improvement) in the capital account balance means money is flowing into the country; the inbound flows represent non-resident borrowings or purchases of assets. A deficit (or deterioration) in the capital account means resident capital is flowing out of the country, in the pursuit of ownership of foreign assets. These statements are simplification of relatively intricate balance sheet operations, but they describe the flows well (see graph below).
Although a higher interest rate relative to those of other major central banks tends to attract funds via the capital account, which acts to raise the value of the domestic currency (USD in this case), rate differentials may not be the primary impetus for the recent improvement of the capital account balance. For instance, pre-COVID-19 pandemic, anecdotal evidence of US real estate assets being attractive to external investors (the US property market was booming) has been highlighted in recent quarters. Foreigners are snapping up US residential and office building properties in increasing quantities, requiring more US dollar-denominated funds. Foreigners have also been eyeing ownership of smaller US technology companies (especially desired by the Chinese), prior to President Donald Trump’s crackdown on Chinese companies operating in the US.
Changes in the US capital account balance lead long-term USD changes by 5-6 quarters
Changes in the US capital account normally show up in the valuation changes of the US currency 5-6 quarters later. Capital accounts improve when non-resident (external) capital inflows increase or resident (domestic) capital outflows slow. The sharp improvement in the domestic capital account since Q4 2018 to Q4 2019 is therefore likely to result in recovery of the US dollar during Q3 this year until Q2 2021.
As we see from the preceding charts as well as the chart above, the recent US dollar weakness was immediately caused by capital flight, but the underlying macro situation has already been laid down by the negative, lagged impacts of recent capital outflows. However, we suggest that this recent episode of dollar weakness is coming to an end. We further suggest that the next bout of continuing strength in the US dollar will come from the steady improvement of the US Capital Account Balance during the period from Q4 2018 to Q4 2019.
The US dollar lost the FX “beauty contest,” but it is fighting back
In the last several months, almost all the macro factors in region to region, country to country comparison were against the US currency, especially those that matter in FX currency valuation. Interest rate spreads between US and Germany (as proxy for EUR short-term rates) were in favor of the latter, as post COVID-19 measures taken by the Federal Reserve brought US short-term rate to near zero. However, that may end soon. US interest rates have risen sharply in recent days, and by late September, the seasonal upturn in US rates across the board should turn that spread in favor of the US dollar.
Moreover, against the EUR, the dollar’s most stalwart rival, GDP growth, spreads now lean favorably towards the U.S. This spread leads the EUR/USD exchange rate by almost six months. The shift lower means that US growth is outpacing that of the eurozone (see chart above). This will become even more significant if the growth outlook for the US in Q3 hews close to what we expect (as discussed below). The EUR should keel over very soon, if it has not already done so.
Short-term changes in US dollar valuation stem from changes in US long-term bond yields
Aside from the broad sweep of positive capital flows, these are other factors which will support the US dollar going forward.
The US dollar (with the DXY Index as proxy) has been weak against a bevy of Developed Market (DM) currencies since March 20 earlier in the year, when the 10-year yield (red line) started to weaken. The dollar has traded sideways to lower, and bond yields went sideways to lower as well.
The primary movers of the short-term changes in the US dollar exchange rate are US long-term rates, specifically the 10yr yield. However, a closer look also suggests that bond yields are to a large degree influenced by changes in systemic liquidity, in this case represented by the Treasury Cash Balance as a proxy for US systemic liquidity. Therefore, in the final analysis, short-term moves in the US dollar are driven by changes in US systemic liquidity flows (see chart below).
In early June, bond yields started to decline in earnest, which, of course, undercut the DXY significantly (green line, see chart above). But the seasonality in aggregate systemic liquidity starts to crank out massive inflows from the second or third week of September (historically speaking), and that should boost yields, along with the DXY. We expect that trend in liquidity inflows to persist until the end of the year. Therefore, yields and the DXY should rise from here, correspondingly.
Growth matters a lot to the US dollar
There is also the matter of what GDP growth should be expected. One of our favored tools is the ISM surveys, both manufacturing and services, and a hybrid ISM, which is composed of 82% services and 18% manufacturing (see chart below). Along with the sharp recovery in risk assets (SPX as proxy), ISM data suggests a sharp turnaround in US GDP during Q3 2020.
The CFNAI is a weighted average of 85 existing monthly indicators of national economic activity. It is constructed to have an average value of zero and a standard deviation of 1. Since economic activity tends toward trend growth rate over time, a positive index reading corresponds to growth above trend and a negative index reading corresponds to growth below trend (see chart below).
The 85 economic indicators that are included in the CFNAI are drawn from four broad categories of data: production and income; employment, unemployment, and hours; personal consumption and housing; and sales, orders, and inventories. Each of these data series measures some aspect of overall macroeconomic activity. The derived index provides a single, summary measure of a factor common to these national economic data. Research has found that the CFNAI provides a useful gauge on current and future economic activity and inflation in the United States.
The “V-shaped” recovery in these indicators argues for much better Q3 GDP data that has been flogged by many analysts. That, in fact, is what is being flagged by the Atlanta Federal Reserve’s GDPNowcast.
The variables that the Atlanta Fed track also suggest a strong rebound in growth in Q3 2020
Latest estimate: 29.6 percent – September 3, 2020
The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2020 is 29.6 percent on September 3, up from 28.5 percent on September 1. After recent data releases by the U.S. Bureau of Economic Analysis, the Institute for Supply Management and the U.S. Census Bureau, the nowcast of third-quarter real gross private domestic investment growth increased from 23.2 percent to 29.6 percent, while the nowcast of the contribution of the change in net exports to third-quarter real GDP growth decreased from -0.03 percentage points to -0.27 percentage points.
Summary and conclusions
The episode of weakness of the US dollar is about to come to an end. Shorting the US dollar has become a one-way bet, and therefore, this short trade is going to unwind quickly. As of the past several weeks, the number of futures contracts amid the speculator community that were net short the DXY (via other FX pairs) was tied for the highest on record going back to the late 1990s.
With everyone – literally – on Wall Street now short the dollar, the only possible real conclusion is that there is virtually nobody else left who can add to dollar shorts, which means that absent some unexpected socioeconomic disaster in the US, the only possible move for the dollar at this point is higher.
Moreover, given the prospects of rising yields and better than expected GDP growth in Q3 2020, the US dollar is a trade that is screaming to be bought.
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Disclosure: I am/we are long DXZ0. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Originally published on Seeking Alpha