[AndrewWoo]

As we have clearly seen in recent months, the improvement in cyclical momentum and accompanying ‘risk rally’ has again been associated with Dollar weakness. However, this negative relationship between the Dollar and risk sentiment has been a relatively recent phenomenon, a trend that has gained momentum over the last 5 years or so.

Structural and Cyclical Forces behind the ‘Risk-on’ vs Weaker Dollar Correlation
From 2003/04 to late 2007, we saw big declines in the Dollar. During this time, we also saw huge equity market gains with SPX rising around 50%. There were powerful structural forces behind these market movements. Mainly, the widening US current account deficit which precipitated the decline of the Dollar. This coincided with a pick-up in the growth cycle and the stock market boom. This strong growth phase also led to a run-up in oil prices. The Dollar’s negative correlation with oil prices, driven partly by oil-producing countries shifting their imports away from the US and to Europe and parts of Asia in recent years. An improving growth environment led to a rise in risky assets, including oil prices, which then in turn led to more pressure on the Dollar.

During this period, we also witnessed massive reserve accumulation by foreign central banks. This may have led to extra demand for USD reserve assets, which may have resulted in such assets becoming slightly overpriced, crowding out some private investors. However, US government securities in particular are among the most liquid assets in the world, hence in periods of rising risk aversion liquidity trumps valuation and foreign investors come back and try to protect wealth in the deep and liquid US Treasury market.

Finally, one important reason that contributed to the negative correlation between Dollar and risk during this period was the proliferation of carry strategies. The buying of high yielding currencies against the Dollar during this risky asset bull-phase, gave rise to an increasingly negative correlation between ‘risk-on’ and the Dollar.

Fast forward to more recent times, this negative correlation has not only persisted, but has gained further momentum. While the structural factors may have faded somewhat, there are now powerful cyclical dynamics that are driving this correlation. This includes firstly, the fact that the Fed has been one of the most aggressive central banks in the world in loosening its monetary policy stance. The accommodative stance has bolstered risk sentiment but weighed on the Dollar. Secondly, the stabilization in the growth cycle and reduction in global imbalances, has set the stage for the return of carry strategies and thus a weaker Dollar, when used as a funding currency. Additionally, the Dollar had strengthened sharply during the deleveraging phase and has since given back only half of those gains. Further declines in the Dollar could just be a continuation of the normalization process.