The US dollar is on the cusp of making a major move. The question is which way will it go, higher or lower? The directional movement of the US dollar will have significant asset performance implications once the tug of war between dollar bears and bulls is resolved.
The US dollar index has been consolidating its 2018 gains for the better part of six months and is currently in the process of forming what market technicians call an ascending triangle formation. It’s supposed to be a bullish pattern, but the reality is that technical analysis rules of thumb rarely stand up to statistical tests of significance. Regardless, what the pattern tells us is that supply of dollars emerges as the US dollar index approaches 98 and demand emerges as it approaches 96.5. The fact that the triangle is narrowing simply indicates that one of the two sides will prevail soon.
Setting aside the chart pattern setup for a moment, we also observe an historically very low level of volatility between the US dollar and its major currency pairs. In fact, our FX volatility index (which is just the average annualized volatility of the US dollar vs six other major currencies) stands at just 5.2%, a level that has been reached only four times in the last 40 years or so. Since FX volatility is mean reverting – hovering between about 4-14% pretty much all the time – we have every reason to expect FX volatility to resurface sooner rather than later.
The coiled springs of supply and demand points converging and historically muted FX volatility means the US dollar could be in for a fierce move in one direction or the other. For asset allocators, this has huge implications for how one ought to position a portfolio. The three asset classes most at risk of dynamic out or underperformance based on the direction of the dollar move are US small caps, emerging market stocks, and gold.
As we show in chart 3, US small cap stocks tend to outperform the S&P 500 when the dollar rises. The phenomenon is due to the relative domestic focus of small caps compared to larger stocks with more foreign currency exposure. The breakdown of small cap relative performance could be signaling that investors are starting to discount a lower dollar.
On the other hand, emerging market stocks tend to underperform US large caps when the dollar rises. On the next chart we’ve inverted the right axis showing the relative performance of EM stocks vs the S&P 500. The most important factor at play here is the tightening of liquidity that a rising US dollar has on EM economies. Because many EM governments and companies issue US dollar denominated debt but earn revenues in the local currency, a rising US dollar makes debt payments more onerous even though revenue growth may slow or even fall due the economy-wide tightening. The relative performance of EM stocks is currently treading water with the US dollar and not providing a signal one way or the other.
Lastly, gold tends to have a negative relationship with movements in the dollar both in nominal terms and relative to stock prices. The inverse relationship between gold and the US dollar is straightforward enough. Both the nominal price of gold and the gold price relative to the S&P 500 are telling us the US dollar is in for a big move to the upside.
In the end, we are getting conflicting signals from small caps and gold as to the directional move of the dollar, with small caps discounting a lower dollar and gold discounting a higher dollar. That fact alone is a source of opportunity (on the long side of gold if the USD breaks lower and on the relative long side of small caps if it breaks higher). EM stocks are performing in line with what we would expect given the US dollar consolidation. Less ambiguous is the probability of a large dollar move, which appears to be growing by the day. Either way, the tight relationship between the dollar and small caps stocks, EM stocks and gold should provide ample opportunity for investors to benefit and manage risks once the US dollar makes its move.