Today, we may be at a key inflection point for both the future direction of the U.S. dollar as well as market expectations for inflation.
The US dollar, as measured by the US Dollar Index (DXY), is at the top of a trading range that has been in place since the start of this year (Chart 1). In fact, it is threatening to break out of the top of this range. A stronger US dollar has been linked to recent equity market volatility, in part because of the way that it destabilizes emerging market economies. Many EM countries have large amounts of USD-denominated debt, and a stronger US dollar makes it more expensive to pay back that debt and can lead to a debt crisis. The recent surge in the US dollar accelerated with the Fed's 9/26 statement and more hawkish tone. We believe if the dollar breaks through the trading range and accelerates, the return of optimism to the equity markets may prove short-lived.
Inflation expectations, as measured by the breakeven on the 10-year Treasury Inflation Protected Security (TIPS), are the mirror image of the dollar's trading range. Since the 9/26 Fed announcement, inflation expectations have slumped and are now at the bottom of the trading range in place since early 2018. A rising US dollar is often disinflationary, making imports cheap. Not surprisingly, inflation expectations have fallen in recent weeks, along with stocks. Inflation is like the thermometer of the economy, taking measure of the pulse of the nation - when it falls too low, the patient is ill.
Why should equity investors care?
We believe that if the US dollar breaks out, EM markets will again likely be under pressure and inflation expectations will slump. Slumping inflation expectations are also consistent with a poor outlook for the economy (lower stocks), lower tax revenues, and a much larger deficit. This turn of events would bode ill for risk assets. The markets are telling the Fed not to tighten any more, otherwise an equity market correction may turn into something worse.
If these levels hold and inflation expectations stabilize, and the US dollar rally remains contained, and the Fed gets the message, 2019 could be a better year for risk assets.
U.S. Dollar Index
(Source: Bloomberg. Data accessed on 10/31/2018)
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