Column: Dollar smiling from ear to ear
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[September 22, 2021]
By Mike Dolan
LONDON (Reuters) - Whether investors run for the hills or not after the
past week's stock market shakeout, the episode provides a glimpse of
where to run for cover - and the U.S. dollar came up trumps.
Dollar cash has routinely provided a haven during moments of global
funding stress in the past - most recently as the coronavirus pandemic
unfolded in March of last year.
The anxiety about a likely debt default by giant real estate firm China
Evergrande - and even feared ripple effects across regional property
firms, high-yield debt markets and banks - may not be quite on that
scale.
But the worries provided enough of a trigger for the steep pullback in
world shares this month, and the dollar has been one of the few clear
winners during the turbulence.
Although that stock correction has been widely predicted - with a
majority in a recent Deutsche Bank client survey saying they expected a
5-10% correction by year's end - the peak-to-trough plunge in MSCI's
all-country index this month almost reached 5% on Monday.
China property nerves are far from over, and financial volatility gauges
are their highest in months.
The dollar has performed impressively as a haven, its main trading index
gaining more than half a percent over the last week - and it was up
almost 1% against gold, more than 1.4% against sterling, almost 7%
against Bitcoin.
Rival havens such as Japan's yen and the Swiss franc matched or
outstripped that over the seven days just gone - but the dollar is
clearly pumped up independently.
Of course, it's not all down to stress. The other big event of the week,
the Federal Reserve's latest policymaking meeting, provides alternative
fuel for the currency.
And some currency strategists see the dollar now getting a peculiar dual
boost.
JPMorgan's Paul Meggyesi and team reckon the greenback stands to gain
from both corners of the so-called 'dollar smile' at the same time.
That 'smile' describes the observation that the dollar tends to benefit
from both extreme stress and tension at one extreme - when highly
dollar-borrowed firms around the world scramble for dollar cash and
liquidity - and from rapid world growth and risk taking at the other -
where U.S. equity outperforms and U.S. rates push higher. In between,
it's at its weakest.
"Our confidence has increased that the dollar is on the cusp of a
clearer break-out from either end of the dollar-smile, or indeed both
ends concurrently," the JPMorgan team wrote.
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Four thousand U.S. dollars are counted out by a banker counting
currency at a bank in Westminster, Colorado November 3, 2009.
REUTERS/Rick Wilking/File Photo
On the left side of the smile, they see growing angst that world growth has
peaked, policy support is being withdrawn, global stocks are overstretched and
there are "mounting global tail risks" from China and related geopolitical
fears.
On the right side stands the Fed and "U.S. rate-driven exceptionalism", they
say. Fed policymakers this week are likely to signal the start of U.S. interest
rate hikes from late next year and - crucially - up to six increases through to
end-2024.
REAL TIME
Interest-rate support for the dollar is sometimes overlooked by focusing on
nominal U.S. bond yields in isolation - especially in a year like this one, when
the dollar held firm even as U.S. Treasury yields recoiled during the summer.
A better measure of the dollar's fortunes is often seen in relative real, or
inflation-adjusted, bond yields between the U.S. and other major economies or
regions.
Having spent most of 2021 in negative territory, for example, the gap in
two-year real yields between the U.S. and Germany turned positive last month,
and this week the new premium on U.S. rates hit its highest level since June
2020. Ten-year equivalent U.S. rate premia are also at their highest since
April.
This real rate view makes sense to those who see inflation expectations and
growth potential dominating a currency's fortunes.
All things being equal, a tighter monetary policy today means lower inflation
expectations, less erosion of the currency's value over time and a higher
currency rate - all assuming growth potential is robust enough to sustain high
rates and a higher 'terminal rate' in the tightening cycle.
And that needs to be set against growth and inflation expectations in Europe or
Japan.
Morgan Stanley's Matthew Hornbach and team also see the dollar lifted further by
the rising real rate view. And they think this week's Fed meeting could be a big
moment.
"The September FOMC may be a key catalyst driving U.S. (real) yields higher,
which we expect to boost the dollar broadly," they wrote this week.
(by Mike Dolan, Twitter: @reutersMikeD; Editing by Kevin Liffey)
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