Fade The Rally, The Dollar's Destiny Is Lower

Authored by Simon White, Bloomberg macro strategist,

Debt-ceiling worries are driving the dollar up for now, but real yields, the fiscal deficit and structural overvaluation favor the medium-term downtrend remaining intact.

All of the recent move higher in nominal yields (discussed here) has been driven by real yields. Inflation, erroneously, is seen as yesterday’s problem, with breakevens remaining near the lower end of their two-year range.

Higher real yields might be expected to be good for the dollar. The currency has indeed risen in recent weeks, but this is more to do with safe-haven demand in the event the debt ceiling becomes binding.

In fact, using real yields on their own to gauge the performance of the dollar risks oversimplification. Higher real yields aren’t an automatic boost for the currency.

To understand why, we must look at the real yield curve.

This gives us a proxy for the real return an FX-hedged overseas investor would get for buying longer-term US debt. Dollar returns at the margin are driven by this, as can be seen in the robust leading relationship in the chart below.

The chart also shows that it is short-term real yields that have been rising more than longer-term real yields, flattening the real-yield curve, a process that started last summer ahead of the dollar’s peak in October. The flattening trend is intact, strongly suggesting the dollar will continue its decline once the debt ceiling is out of the way.

This cyclical outlook accords with two important structural factors that are dollar negative.

The first the US’s yawning fiscal deficit. At ~7% of GDP it is among the largest of major countries, and is historically wide - even before the US has entered a recession.

Furthermore, the US currency remains one of the most overvalued. The dollar’s real-effective exchange rate continues to look expensive on a long-term basis, even after the last eight-months’ sell-off.

Tellingly, the dollar’s weakness is not eliciting the typical demand for trade, cross-border credit and FX reserves it would normally, strongly suggesting its dominance has peaked.