The Dollar, Emerging Markets, and Volatility

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).