07 January 2025
Since 2023, our sense is that there have been a few major swings in macro trends (and narratives) that have caught consensus positioning and beliefs offside. In turn that has contributed to some big flips in markets. One of the major trends since September 2024 has been the sharp appreciation of the US dollar and a shift higher in the path of future short-term interest rates. What is unusual (if not unique) about the rise in future short rates and Treasury yields in this episode is that occurred when the Federal Reserve “lowered” the funds rate (eased monetary policy chart 1).
Chart 1
As we have noted in the past, the United States is a long rate economy – most borrowing is done at the longer end of the yield curve. US 10-year yields have “increased” by 100 basis points since September 2024. That has, in effect, “tightened” monetary conditions since the Fed commenced cutting the policy rate. The correlated implication for markets has been a 9% rise in the US dollar index since September which has coincided with a meaningful (9.6%) correction in EM/Asia equities over the same period (chart 2).
Chart 2
The reflexive appreciation of the dollar and correlated impact on interest rates, equities and volatility originates from the central role that the dollar plays as the global reserve currency. More debt is issued in US dollars than any other currency (around 40% of all short-term debt and 50% of all long-term debt). The US dollar also remains dominant in central bank reserves, capital flows and trade. It is also important to remember that currencies are always a relative price. Interest rates, growth, inflation, and external positions are always relative considerations in foreign exchange. While debt to GDP is high in the United States and it might now be in a phase of “fiscal dominance” there is also a lot of external debt denominated in dollars. In the near term, the larger fiscal impulse in the US has likely supported relative growth and returns on US assets.
Of course, the rise in the US dollar and US yields since September was in anticipation of a Trump/Republican victory in November 2024. That was also evident in the performance of stocks and sectors within the US stock market. Markets priced the positive elements of the policy agenda such as tax cuts, de-regulation, and higher potential growth. Conversely, tariffs were perceived to be more challenging for emerging markets and non-US assets. In the near term, relative fundamentals favoured US markets and the US dollar.
The good news looking forward is that US dollar strength and a higher path for US interest rates (a higher neutral and terminal rate for the Fed) is both the dominant prevailing bias and a crowded long position for most investors. Although it is important to be careful of “overlay” charts, the dollar has already priced comparable strength to the episode following the first Trump administration (Trump 1.0 is the dark blue line compared to Trump 2.0 – light blue line in chart 3). If the US macro news flow, particularly the labour market (which is important for the Fed’s reaction function) softens, it is possible that the recent phase of dollar strength might be near a peak.
Chart 3
On the negative side, phases of dollar strength often led to episodes of volatility because liquidity, volatility and leverage are intimately linked (hence the dollar wrecking ball – chart 4). As we noted above, higher Treasury yields, a higher expected path of rates and US dollar strength since the Fed curt the policy rate in September 2024 have, counter-intuitively, tightened broad monetary conditions. The context is that the equity and credit risk premiums are modest, and the cost of protection (volatility) is modest for the potential risk. In Asia and EM, the drawdown from the reflexive impact of the dollar, rates and liquidity has already been significant. That is also an opportunity if there is an unwind of dollar strength and crowded positions.
Chart 4
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