The US Dollar Index (DXY) peaked at the end of Q3 staging a close to 20% rally for 20221. After trading range-bound, it started to fall more meaningfully on 3 November and is down close to 4.5% for the month. This has helped risk assets do well and could be the premise of a weaker dollar in 2023. Dollar bulls may have seen their best days, but the volatility of recent data means that bears may have to hibernate a little longer before a meaningful downtrend is engaged. Until then it may be worth starting to consider currency hedged exposures for euro, sterling and Swiss franc investors as 2023 commences. Market timing is a notoriously delicate exercise, but reducing risk is a process where currency hedging can help.
The dollar smile theory was developed by Eurizon’s Stephen Jen when working at Morgan Stanley in 2001 and can be pictured as follows (figure 1):
- When the US economy significantly outperforms the rest of the world, the US dollar tends to be strong and increase in value relative to other currencies.
- When the global financial markets are disorderly, and sentiment switches to “risk-off“, since the US dollar is perceived as a safe-haven currency, investors in their quest to safety tend buy the US currency causing it to rally.
- The US dollar weakens to the bottom part of the smile when the U.S. economy grapples with weaker economic fundamentals or when there is global synchronized growth. The possibility of interest rate cuts also drive the US dollar down, but it will be dependent on expectations of the future direction of interest rest differentials.
Figure 1: Graphical view of the US dollar smile
As an illustration of the smile and safe haven, the below graph illustrates the many phases of dollar strength due to safe haven demand in the past 40 years. Drawdowns from the S&P 500 index have all been below 20% (i.e. in bear market territory) during these periods. 2022 was no exception and the dollar smile theory has worked.
Figure 2: Performance of USD during safe haven periods
Dollar cycles do not have exact lengths and are contingent on many dynamics both economical and geo-political as history can attest (see figure 4). However we have witnessed the longest “bull” cycle of the past 50 years and based on all metrics the US dollar is overvalued vs most developed (and emerging) market currencies.
Figure 3: Currency valuation relative to the US dollar
Figure 4: Narrow Trade Weighted US dollar real effective exchange rate since Nov’ 1965
In 2023 the short term direction of the US dollar will still hinge on inflation, risky asset behaviour against a backdrop of deteriorating economic numbers and potentially slowing FED. However the first months of 2023 may be a bit more challenging.
The market rebounded strongly in November after the inflation print miss (7.7% yoy for October vs 7.9% expected) but inflation still remains elevated and the rate cycle is not over yet. Meanwhile PMI numbers remain weak and deteriorating in the industry. Indeed the J.P. Morgan global manufacturing PMI report for November was a down. The output series tumbled 0.9 points to 47.8 and the ratio of orders to inventories fell to a new low, consistent with a recession in global industry.
The US job remains too tight to make the Fed pause but employment numbers are typically lagged indicators of activity. As a result rate differentials may not reduce as quickly as warranted to result in a weaker dollar in the early stages of the new year.
Indeed State Street Global Advisors’ outlook can be summarized as follows: softening demand and aggressive rate hikes increase downside risks to the baseline “Growth Recession” view. The sub-trend growth is to persist into 2024.
A disinflationary episode is ahead of us and the Fed’s inflation obsession will gradually shift to growth worries, leading to rate cuts by Q4 2023. This should then lead to USD decline as long as global growth dynamics do not deteriorate much further.
The second half of 2023 could thus mark the beginning of a depreciation regime. China may finally be exiting its harsh Zero Covid policy and Europe could be starting to recover. As described in figure 1, a rest of the world economic recovery tends to see USD depreciation through the middle of the USD smile. Additionally, some analysis (Citi) shows that the USD tends to depreciate by circa 8% for the following 6 months after an equity market bottom. If the US curve is bull-steepening at the same time, which would be in line with our current outlook, this can add to USD downside.
Overall risk sentiment matters in the short run as we can see in figure 5 where equity market performance is inversely correlated with the USD strength.
Figure 5: Global Equities vs US dollar real effective exchange rate (REER)
For traditional bond and equity indices, index providers offer monthly hedged benchmark rolling 1 month FX Forward in line with the currency weights as of end of month. However in some cases for single currencies or when the underlying asset is volatile, specific hedging methodologies are followed in order to comply with European regulation.
For example the S&P 500 EUR Dynamic Hedged Index represents a close estimation of the performance that can be achieved by hedging the currency exposure of its parent index, the S&P 500 Index, to EUR. The index is 100% hedged to EUR on a monthly basis, by selling USD forward at one-month forward rates. The S&P 500 EUR Dynamic Hedged Index includes a mechanism that aims to ensure that the index does not become over-hedged beyond 105%, or under-hedged below 95%, of the parent index currency exposure, whereby if either threshold is breached, an intra-month adjustment to the index is triggered to reset the hedge ratio to 100% after the close of the following business day.
Other currency hedging approaches can be implemented, in particular for Emerging Market Debt local currency where, the cost of hedging each EM currency back to EUR, or GBP, would be prohibitive. A weaker dollar tends to be a positive driver of performance for emerging market debt local currency strategies, but if it is concomitant with a stronger EUR/USD rate, then part of the performance is lost.
In the case of the Bloomberg Emerging Markets Local Currency Liquid Government Bond Index unhedged USD base hedged into EUR the index is 100% hedged to the EUR by selling the base currency of the parent index (USD) forward at one-month forward rates. This can be quite interesting for investors looking to benefit for a more advanced rate cycle in EM than DM in 2023 while reducing the USD weakness risk.
For international investors, currency movements can be a major driver of returns across asset classes. This is especially true in a low-return environment where currency swings can overwhelm the returns of the underlying asset.
Hedging selected currency exposures allows investors to focus on the return drivers that they want to own and reduce the number of variables affecting portfolio performance.
SPDR ETFs offer investors cost-effective, flexible, transparent tools for managing currency exposures across equity and fixed income allocations. Built through partnerships with investors and index providers and fueled by our institutional expertise, our currency-hedged share classes allow investors to target their exposures.
Source: Bloomberg Finance L.P., State Street Global Advisors as of 30 November 2022.
Learn more about Currency Hedging with SPDR ETFs.
1 Source: Bloomberg Finance L.P in USD from 12/31/2021 to 9/30/2022.
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