The ‘dollar downfall’ narrative has dominated market commentary from a wide range of sources in recent months, but the pace of the dollar’s decline slowed notably throughout August and September. This leaves us questioning whether the slide in the dollar that was so prevalent throughout June and July has reached the end of its course, or whether what we are seeing now is simply a period of consolidation before the next leg lower unfolds?


Background

We’ve long become accustomed to the notion that the dollar outperforms its peers during times of market panic and hence it was no surprise to see the greenback make strong gains during the height of the COVID-19 crisis in late March. However, since June, the dollar has come under heavy pressure, fueling expectations that this could be the start of a much bigger change in fortunes for the US currency. As discussed previously, the main dynamics weighing on the dollar have been as follows:

  • The perception that Europe is in a stronger economic position than the US right now
  • The belief that we  may be nearing the end of the COVID crisis
  • The notion that the US dollar might lose its reserve currency status
  • The theory that the US dollar may be subject to increased inflationary pressure resulting from extreme monetary stimulus.
Current Situation

Looking at the factors above, point 4 still rings true. Point 3 was always something that would play out over a much longer time horizon and therefore can be discounted, particularly when thinking about things from a short-term perspective. However, point 2 is starting to look a little over-optimistic and if infection rates (and ultimately death rates) start to rise again, we expect to see the market return to ‘risk-off’ mode very quickly. Finally, the US economy has fared better than Europe (although we note US unemployment is marginally higher).

This week, global deaths passed the 1 million mark, while infection rates are on the rise again in countries that seemed to have had their outbreaks under control a month ago. In the UK, the government has reimposed restrictions on socialising and recommended that people should work from home where possible. Quite rightly, an effort is being made to avoid a full lockdown that would send the economy into reverse again, but any hope of a V-shaped recovery is looking increasingly remote.

What are markets telling us?   

Although the dollar has gained a couple of cents on both the pound and the euro, markets still appear relatively calm. Looking at the VIX Index (volatility on the S&P500, widely regarded at the market’s ‘Fear Index’) we remain elevated compared to February, but nothing like the levels we saw in March or April. Bar the odd spike, the index has been relatively calm since the beginning of July.

Chart 1: VIX Index – 1 year
Source: Bloomberg

Meanwhile, volatility in the FX markets is also surprisingly subdued. Looking at the chart below, EURUSD vol (blue) and USDCAD vol (green) have been particularly sedate and although GBPUSD (red) is slightly elevated, this is probably more to do with Brexit uncertainty than COVID.

Chart 2: GBPUSD (red) EURUSD (blue) and USDCAD (green) 1 year implied volatility
Source: Bloomberg

Likewise, risk reversals (the price you pay for protection against a move lower in the dollar vs what you pay to protect against a move higher) remain relatively flat for both EURUSD and USDCAD. Obviously GBPUSD is once again skewed by Brexit risks.

What can we conclude? 

Although equity markets have eased back from their early September highs and the dollar is a touch firmer against most of its major counterparts, we are a far cry from the market turmoil that we saw back in March and April. Maybe it’s the result of governments managing to avoid another full lockdown (for now) or maybe it’s a consequence of market’s faith in the various stimulus efforts provided by both Governments and Central Banks. Or maybe, we’ve all become immune to bad news and believe that science will prevail with a vaccine in the not too distant future.

Either way, as risk managers, our first thought is one of caution. If fear does escalate, current market conditions will look very attractive for hedging. However, by the time fear does set in, volatility will have already risen, and it may be too late to act.

With regards to our view on the dollar, we have been cautious about the dollar downfall narrative from the beginning and the current situation justifies our thinking. Whether this turns out to be a correction within a longer-term downward trend or whether we’ve just witnessed a correction in an upward trend remains to be seen. All we know at this stage is that we could be in for a bumpy ride.

Author: Marc Cogliatti