Does Secular Stagnation Help The Dollar?

The Dollar Index has broken to a new high for the year – largely on the back of weaker growth prospects overseas. If secular stagnation fears grow and asset allocation shifts towards bonds from equities, prohibitively high dollar hedging costs could mean the dollar does even better.

Secular stagnation fears in the ascendancy

This week the trade-weighted dollar has rallied to a new high for the year. This has been driven less by US growth news, but more by sluggish activity and softer monetary policy prospects in the rest of the world. In fact, most fund managers have a growing conviction that the world economy is entering into a period of low growth and low inflation - or secular stagnation.

Fanning the fears of low growth and low inflation this week have been: soft CPI readings in Australia, continued pessimism from European manufacturers (German IFO) and a poor 1Q19 GDP release from Korea.  We’ve also seen a dovish raft of central bank communication from the likes of the Bank of Canada, Sweden's Riksbank and, surprisingly, the Central Bank of Turkey.

Despite prospects of some better US activity data near term, the interest rate market has struggled to shrug off fears of a slowdown.And while the jury is still out on whether a flat/inverted yield curve foreshadows the next US recession, the dollar continues to perform well. In fact, the dollar index (DXY) has broken to a new high for the year and has now reclaimed around three-quarters of the decline since Trump took office in January 2017.

Despite US yield curve flattening, the dollar rallies

(Click on image to enlarge)

Source: ING, Bloomberg

Asset allocation shift to bonds from equities?

If increasing fears of secular stagnation are realised, we would expect to see the investment community (eg, those running balanced funds which invest in both equities and bonds) rotate away from equities and into the bond market.

Buy-side surveys suggest investors are still underweight bonds and overweight equities, although there is some evidence that the rotation (at least in US asset markets) is already underway. Here the US Treasury releases its Treasury International Capital (TIC) data series, showing foreign purchases of US securities and US purchases of foreign securities. The data (as of February 2019) shows consistent foreign private sector purchases of US bonds (Treasuries, Agencies and Corporates). In contrast, foreigners have sold US equities for the last ten months.

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