Is the US dollar too expensive?

Simply put turns to all things currency this week, distilling what fluctuations in the US dollar mean for investors. What do current levels tell us about the currency and its function as a diversifier in a multi-asset context?

Fasten your seatbelts

It feels like the end of the cycle. The US Federal Reserve (Fed) has just cut policy rates for the first time since the start of its tightening cycle, which began in 2021. The main reason for this significant shift is the dynamics of the US job market: the central bank senses an unwelcome deterioration in US economic data. The eurozone has witnessed a similar softening, prompting the European Central Bank (ECB) to cut rates at its September meeting. So, fasten your seatbelts, our central bankers collectively foresee a zone of turbulence.

The magnitude of the turbulence could be hard to quantify: it might be light, like a soft landing, or more sizeable, like a hard landing. Either way, central bankers now anticipate that the good times are behind us. The Fed put is keeping a watchful eye on things, but there's nothing to stop us considering the best options to protect our portfolios should a larger-scale slippage occur.

In such circumstances, the US dollar is usually considered a fallback asset, but is that status foolproof? In this week’s edition of Simply put, we examine how well the US dollar has performed during recent periods of stress, and whether it has now become too expensive.

The dollar and the flight to liquidity

Historically, during a phase of market stress – when investors collectively seek to sell their cyclical assets and take refuge in hedging assets – the dollar has occupied a special place. Indeed, this flight-to-safety phenomenon is generally accompanied by a flight to liquidity: wherever possible, investors abandon their less liquid investments in favour of more liquid ones. This has an inter-asset class effect, as well as an intra-asset class effect. In the world of currency markets, the liquidity of the dollar dominates the foreign exchange (forex) market: the dollar is still the world's most-traded currency. So, during periods of stress, it's common to see the dollar generate abnormally high returns.

Figure 1 below illustrates this point using our in-house risk appetite indicator. The higher this indicator, the greater the risk appetite, which mainly reflects the fluctuation of implied volatilities and credit default swap indices. The chart shows the average performance of the trade-weighted dollar as a function of the level of risk appetite as measured by our indicator. It clearly shows this outperformance during stressful periods: when our indicator is in its lowest quartile, the dollar has generated a return of around 7%, compared with a return over the entire 1996-2024 period of 0.5%.

Further breaking down performance and focusing on the pre-Covid decade and the post-Covid period, this effect is even more magnified, with a stress-phase performance of 17%¹. From this perspective, the dollar has lost none of its ability to attract financial flows during periods of rising stress. The question is whether this safe-haven status is already largely reflected in its price or not.

FIG 1. Annualised performance of the dollar as a function of the LOIM risk appetite indicator

Source: Bloomberg, LOIM. As of 19 September 2024. For illustrative purposes only.
 

The dollar is expensive

If the dollar is to protect a portfolio in the event of a bear market, it must generate asymmetrical returns, as is generally the case for undervalued assets. This notably occurred with government bonds during the mini-bear market at the beginning of August 2024: bonds diversified nearly perfectly after a few quarters of seeding doubts about their diversification qualities. According to our valuation metrics, bonds were 'cheap' at the time. But what about the dollar?

The medium-term value of a currency primarily depends on two factors: inflation within the currency zone relative to its trading partners, and the spread between its interest rates and those of its trading partners. Higher inflation is unfavourable for the currency, while higher interest rates positively influence its value. These two factors are currently at odds: both inflation and interest rates are higher in the US than the G10 average, particularly compared to the eurozone.

Figure 2 shows a fundamental valuation of the EURUSD since the fall of the Berlin Wall, based on inflation and interest rates differentials. As can be seen from the chart, the EURUSD fluctuates around its fundamental value (notable deviations occurred in 2000, 2008 and 2022). While it was cheap before the third quarter of 2008, explaining its strong diversification impact during that period when the US was the epicentre of the financial crisis, today it is already considered expensive. As discussed previously, a large part of this high price can be attributed to the attractiveness of US equities. The currency's already elevated price could work against it, limiting its advance to 10%, as it is already 10% overvalued. Right now, the Bloomberg consensus view points to the EURUSD being at 1.16 by the end of 2026: another sign that the dollar is perceived as being expensive.

FIG 2. Fundamental valuation of the EURUSD as a function of inflation and interest rate differentials

Source: Bloomberg, LOIM. As of 19 September 2024. For illustrative purposes only.
 

What this means for All Roads

Our All Roads strategy suite has no systematic exposure to the dollar or to currencies in general². In the absence of robust tactical signals, we believe that currencies add risks to portfolios that are not remunerated in the same way as common risk premia (e.g. bonds and equities).

The above arguments support our choice to seek alternative sources of diversification rather than a buy position in the dollar, which does not currently appear to be the best option in terms of convexity anyway, in our view. Equity volatility, for instance, remains low (although it is higher than it was two months ago), and our risk modelling signals and our trend-following overlay have recently supported an increased exposure to bonds within our allocation mix. At this stage, we prefer to seek convexity in allocations to long volatility strategies as well as bonds, rather than placing an outright bet on the dollar.

Simply put, while the dollar could benefit from a rise in market stress, we believe it already appears expensive.

Sources

[1] Source : LOIM and Bloomberg.
[2] Holdings and/or allocations are subject to change.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

•    Growth signals continue to point to a period of slowdown but the deterioration has stopped and now 55% of them show a progression
•    The inflation indicator continues to progress, with 67% of data currently rising across our country-level indicators
•    Consistent with the other two indicators, the monetary policy signal has progressed over the week while staying in the dovish zone

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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