The US Dollar's fading credentials as a place to hide

Tom Traill - 22 November 2018

October’s US equity market correction has provided another opportunity to gauge the credentials of so-called risk-off assets. In what has been dubbed “the everything bubble”, the search for hiding places is intensifying: one day, it may even supplant the search for yield. While emerging market assets and commodities have sometimes served as risk diversifiers, both are vulnerable to an Overmighty US Dollar. So, how useful is the US Dollar as a refuge from the storm? Less than you might think.

The S&P 500 index completed a near-10 per cent correction on 29 October in the context of geopolitical concerns over trade and tariffs, a Federal Reserve intent on further rate increases, a flurry of moderately disappointing corporate earnings statements and a jump in 10-year bond yields to 3.22 per cent.

Because most investors have a degree of home bias, the typical reaction to a US equity market decline is for US investors to liquidate some of their international assets. Although a similar reflex is at work in other geographies, as the biggest overseas investor, US asset repatriation tends to make the largest waves in capital markets and currencies.

Consequently, we are used to observing US Dollar rallies alongside US equity market corrections. The typically negative correlation (figure 1) between “risky” asset prices and the US Dollar in times of stress (but not necessarily at other times) has entered market folklore.  Many investors routinely park the proceeds from the liquidation of equity holdings in US Treasury bills or Dollar bank deposits to take advantage of the protective attribute of the US currency.

However, whether examined only in the context of episodes of equity market stress (figure 1) or on a rolling correlation basis (figure 2), the US Dollar’s credentials as a risk-off asset have faded markedly since 2012. While the US Dollar would have neutralized around 23 per cent of the recent drop in the S&P 500, this is a far cry from the 40 to 50 per cent that prevailed during 2004-12 corrections. Has the Dollar leopard lost its spots?       

The US is running twin budget and external deficits with no sign of a policy change on the horizon. While monetary policy has been tightened, there still seems to be plenty of inflationary pressure, particularly in the labour market and imports. Furthermore, President Trump’s approach to international relations runs a tricky gauntlet – it is not inconceivable that one errant threat could cause a significant loss of faith in the currency. China still owns a huge amount of dollar denominated assets, whose threatened sale could be used as a negotiating ploy.

Looking even further ahead, Hans Rosling’s excellent book, Factfulness, highlights (figure 3) that soon most people with level 4 incomes (higher than US$32 per day, essentially consumers) will be non-westerners. He projects that in 2027 the number will be equally matched and by 2040 it will be 60/40. This relative rise in consumption towards Asia is liable to dilute the strength of the US Dollar in the longer term. China’s resentment towards Dollar-centricity is growing, as evidence by its frustration with the SWIFT payment system.    

Figure 1

Data source: Thomson Reuters Datastream

Figure 2

Data source: Thomson Reuters Datastream

Figure 3

Source: Factfulness by Hans Rosling

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