The Dollar is starting to look very weak

The pieces are falling into place for a more sustained decline in the Dollar

On August 2, 2012 - exactly one week after Draghi’s now famous “whatever it takes speech” - Goldman’s FX strategy team (of which I was a member) put out a tactical trading recommendation to go long the Euro against the Dollar. I remember walking across the trading floor after the recommendation went out and getting lots of looks of incomprehension (and pity). This was at the height of the Euro zone sovereign debt crisis. EUR/$ was around 1.20, having fallen from above 1.30 just a few months before. Markets dismissed Draghi’s speech as empty rhetoric. This was peak Euro skepticism.

Goldman’s FX strategy team at the time included two Germans (Thomas Stolper and myself) and one Greek guy (Themos Fiotakis). You can imagine the arguments we had as the sovereign debt crisis unfolded. What gave us conviction to go long Euro after Draghi’s speech was that it was so un-German. Germans believe strongly in keeping monetary and fiscal policy separate. Draghi’s speech muddled that. After all, the ECB could certainly end the crisis by buying Italian and Spanish debt, but doing so would irredeemably damage its independence. We knew something big had happened and it was time for sovereign risk premia to compress, which implied a rise in EUR/$.

There was one big problem with our trade. We had massive event risk the very next day because US payrolls for July 2012 were about to be published. This one print could have blown our trade out of the water within the first 24 hours, but - in the event - the opposite happened. Payrolls surprised massively on the upside and EUR/$ jumped to 1.24 within 24 hours of our trading recommendation going out. That data surprise changed everything. The Euro was back and kept rallying for almost two years.

The reason I’m starting with this story is because of what it says about the Dollar. In the years after the global financial crisis, the Dollar would fall on strong US data. The Fed’s many QE programs were capping nominal yields, so that strong US data pushed down real yields and thus the Dollar. This isn’t what we have today. This correlation flipped in 2014 and - ever since - upside US data surprises have lifted the Dollar, as indeed they have in recent weeks. The reason I switched to forecast Dollar weakness a few months ago is because I believe this correlation is about to flip back. It hasn’t yet, but - with the Fed under assault - it will.

The four charts above are key inputs into how I think about the Dollar. The top left chart shows what interest rate futures price for the Fed’s policy rate at the end of this year. We’re starting to head in the direction of pricing more than two cuts this year. As I noted recently, the worst possible nightmare for Warsh is to have Trump turn on him like he turned on Powell. I think this means we get 100 basis points in cuts in the June, July, September and October meetings that precede the midterms.

As markets move to price more Fed easing, this will pull down the rate differential of the US versus its G10 peers, which is what the top right chart shows. This process has only just begun and has a lot further to run. Best leading indicator for USD direction is the Dollar versus emerging markets (EM), which is the black line in the bottom left chart. This has been declining ever since the Fed’s last rate cut on December 10 and remains near its recent low after all the noise around Greenland. Gold has certainly fallen from its highs but remains 50 percent up from Jackson Hole on August 22 of last year. All indications therefore are for the Dollar to fall further.

The most important thing to watch, in addition to the Dollar versus EM, is how the Dollar trades on data surprises. I expect this correlation to flip back to where it was on August 3, 2012, i.e. for upside US data surprises to drive the Dollar weaker.