IN THIS PUBLICATION:
- The dollar sits at the apex of financial markets.
- The previous dollar weakness was mainly the result of strength in the euro and the renminbi.
- Downside protection is becoming more and more expensive.
The US Dollar, the Euro, and Bond Yields
The Dollar Index (DXY), having bounced off its recent lows, is poised to break higher (the Euro accounts for 57% of the DXY and its direction will be the primary focus of the US dollar discussion – one which we just hosted on this week's ‘Why Does this Chart Matter?’).
Coming into 2021, almost every Wall Street strategist was bearish on the dollar. They expected the combined efforts of US monetary and fiscal policy to outpace all other regions, diluting the dollar and forcing it onto its back foot.
In short, consensus was that loose policy would lead to a weaker dollar.
The thinking was that this weaker dollar would be driven by the real interest rate differentials between the US and Europe. Higher levels of US inflation, driven by looser policy and higher consumer spending were expected to depress real yields at a faster pace than in other regions (Real Yield = Nominal Yield – Inflation). Faced with lower real yields, investors were expected to chase better returns in overseas markets, decreasing demand and putting downward pressure on the dollar.
Effectively, US consumer prices (i.e. inflation) did indeed surge at a faster pace than other regions, pushing real yields to a lower level than in Europe, but not by a significant amount.
Surprisingly (or not), theory did not meet practice, with the real yield differential having a weak correlation to the performance of the dollar versus the euro.
What we’ve seen instead is a dilutive effect caused by different levels of stimulus between the US and Europe, which has worked in reverse (at least, at the monetary level).
When the ECB was expanding its balance sheet (‘diluting’ the euro) at a faster pace than the Fed, the dollar fell against the euro (highlighted below), and vice versa. This is somewhat counter-intuitive – why would the US dollar weaken against a currency that is being printed at a faster pace?
Perhaps sentiment was the key driver.
One of the primary reasons for euro weakness during periods over the last 7 years was capital flight; investors seeking either higher yields within the eurozone or taking capital elsewhere to flee the risk that the eurozone would blow up. What appears to be happening now is that the ECB has effectively guaranteed a backstop to all bonds (a buyer of last resort), which has increased confidence in the European market overall.
This has led European bond yields to converge – case in point is Greek 10-Year bond yields dipping below its Italian equivalent (despite the Euro Cup victory and the runner-up place in Wimbledon [Tim’s note: Diego wrote that last bit and leave it up to a European to count second place as a good thing…let the hate on Twitter ensue]).
Now, there is less need for investors to seek return outside of the eurozone if there are healthy capital gains to be made on peripheral debt within it (0.75% on Greek bonds might not be healthy returns, but look at the zee Germans below).
Another key driver of the dollar has been positioning. After the reflationary boost of the Biden election victory and the successful vaccination news in November 2020, investors bet on a continued period of synchronized global growth.
- During similar previous periods, such as 2002-2008 and 2017-2018, the dollar fell, the price of commodities increased, and emerging markets outperformed. Investors prepared for an analogous outcome in 2021, getting short the dollar, long commodities, and long emerging markets.
- Unlike those two previous periods, however, China was not in a growth at any cost mode. Since 2018, China has been attempting to rebalance its economy toward domestic consumption.
Over the last 12 months, reflationary assets performed well, but without China’s support, reflation trades (long commodities, short bonds, etc.) are vulnerable to gyrations in the dollar and swings in positioning (rather than fundamentally driven by economic data). Emerging markets have already been struggling, and if the dollar breaks higher, many investors will find themselves on the wrong side of the boat.
The US Dollar Headwind for Emerging Markets
Over the last 20 years, there has been a very clear relationship between the dollar and the relative performance of emerging market equities (chart below). When the US Dollar falls (2002-2008), the S&P500 underperforms. When it rises, the S&P500 outperforms. In the last 1-2 years, this two-decades-long relationship has started to break down.
- During the period from 2002 to 2008, China’s entry into the World Trade Organization (2001) and its policy of rapid urbanization created an insatiable demand for commodities. This demand was bolstered by the credit boom that spread from the US.
- Export economies, especially those with a strong commodity base (many of whom are EM economies), saw their currencies rise.
- The dollar fell against those countries’ currencies, as a consequence of global growth.
- A cheaper dollar is a boost for a global economy that borrows in dollars and transacts much of its business in dollars. The weaker dollar, thus, created a virtuous circle that led to emerging market outperformance.
A stronger dollar, on the other side, turns ‘virtuous’ into ‘vicious’.
- Dollar debts become harder to pay back (you need more local currency to pay off each dollar of debt).
- As the dollar rises, commodity prices fall (there is a mechanical relationship between them as most commodities are priced in US Dollars, and therefore, become more expensive).
- Emerging markets with dollar debts and commodity exports (which is most of them) begin to suffer.
During the sluggish rebound from the 2008 financial crisis, US growth stocks (tech) became the best performing equities, driving capital into dollar assets and driving up its value.
Consequently, emerging markets underperformed the S&P500 during this period.
All of this begs the question: why, therefore, have emerging markets performed so poorly, in relative terms, during the last 12 months of dollar weakness?
- First, dollar weakness was not broad-based. The DXY weakness was mainly the result of strength in the euro and the renminbi. If we isolate emerging market currencies, we can see that they’ve actually underperformed significantly.
- Second, China was not growing at the same pace as it had during previous periods. Many reflation assets performed well because of problems with supply, not increases in demand. This means that EM did not benefit from the most important tailwind of past reflationary periods: Chinese demand.
Emerging market currencies never really joined the party. The weaker dollar (which was really a stronger euro), created the impression of reflation and investors jumped on the bandwagon in anticipation of synchronized growth, which has not materialized.
Emerging market equities have also experienced a new headwind. Their composition has been steadily shifting from commodities, banking, and heavy industry toward technology shares, especially in the Asia region.
China’s regulators have been taking aim at these behemoths citing security concerns, with some listings being put off (Ant Group) and others being significantly impacted straight after listing (Didi).
Chinese internet names have, thus, significantly underperformed the tech-heavy NASDAQ100 this year, offsetting many of the benefits that should have accrued to a weaker dollar.
So instead of global synchronized growth, we got global synchronized big tech bullying.
That said, there’s more at risk than just emerging markets. A surging dollar tightens global financial conditions and increases investment risk – and this has a material impact on market volatility.
Falling Volatility but Expensive Protection
The S&P500 volatility index (VIX) looks like it has been well behaved. It’s been edging lower since last year. (*Tim starts salivating…)
Scratch the surface, however, and things become a bit more complicated. The implied volatility (what you actually pay) for the market’s downside rises very sharply.
Let us get a bit more technical (potty break now if you need it), and feel free to reach out if you have any questions. The SKEW index is a measure of the difference between out of the money puts (what you pay for protection) versus out of the money calls (what you pay for potential upside) - some people consider this another gauge of ‘fear’.
Investors accept that the volatility on lower strike puts in an equity index is usually more accentuated than for higher strike calls that are equally far away from the current level of that index. But the SKEW index recently made a new all-time high, which implies that demand for protection is now significantly higher than demand for potential upside when compared to the past.
Perhaps investors have already been buying protection, pushing up the price of puts versus calls to a record level.
A side effect, however, is that the cost of buying simple protection for a regular decline (e.g. 10%) is prohibitively expensive. Very few will want to pay that despite there being many red flags:
- The US market has been carving out new all-time highs in recent sessions with fewer and fewer stocks participating in the move (called ‘weak breadth’).
- The risk of a stronger dollar is increasing, which correlates negatively with the S&P 500.
- US household equity exposure is at its highest level ever and yet very few investors have a protection strategy in place.
Picture the Zoolander gasoline fight scene. That’s what the market is looking like right now… But if markets over the last ten years offer any clues, Brint won’t be lighting that cigarette.
Watch how volatility develops in the near future, especially now that buying downside protection is more expensive, as it might signal how quickly the market can turn if Central Banks don’t step in as they’ve now accustomed us to.
That said, even if there is to be a spike in volatility, we do believe that Central Banks will ultimately bail out market participants. Recent examples of central bank support include the reversals of the 35% decline in March 2020 and the 20% decline in December 2018 (although the Fed were instrumental in creating the latter event).
We do not see this changing anytime soon. (Regardless of how many #volatilitymatters tweets Tim puts out there)