UUP – UUP: Expect U.S. Dollar Rally On Safe Haven Status
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What a change in the macro landscape within a few short weeks. The last time I wrote on the Invesco DB US Dollar Bullish ETF (NYSEARCA:UUP), inflation was top of mind for many investors and my bullish thesis on the UUP fund was predicated on the Fed forced to honor its ‘higher for longer’ pledge on raising interest rates.
Inflation Is Higher For Longer
In fact, I was correct for a few weeks, as higher than expected inflation have kept the Federal Reserve’s focus squarely on additional interest rate increases, which was positive for the U.S. dollar.
First, as I predicted, the January CPI figures released on February 14th showed higher than expected headline and core CPI inflation of 6.4% YoY and 5.6% YoY respectively. This was followed by PPI inflation of 5.4% YoY vs. expectation of 4.9% and Core PCE inflation of 4.7% vs. 4.3% expected (Figure 1).
Figure 1 – Inflation has been hotter than expected (fxstreet.com)
February’s inflation figures continued the hot trend, with headline and core CPI readings of 6.0% and 5.5% respectively, supporting my ‘higher for longer’ thesis.
As recently as Fed Chair Powell’s testimony to the Senate and Congress on the week of March 6th, 2023, he was still laser focused on maintaining interest rates ‘higher for longer’: (author highlighted important passages from a USA Today article covering the testimony)
“As I mentioned, the latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell told the Senate banking committee in prepared testimony.
He added, “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”
Once a peak rate is reached, he said, the Fed will likely “maintain a restrictive stance of monetary policy for some time,” signaling that rate cuts aren’t likely this year even if the economy weakens as expected.
But Bank Failures May Force Fed To Pause
However, the subsequent collapse of several large regional banks and Credit Suisse, a G-SIFI (Globally Systemically Important Financial Institution), appear to have changed the Fed’s calculus.
Although the Federal Reserve still raised interest rates by 25 bps at the most recent March 22 FOMC meeting, there is now widespread debate as to whether this will be the last rate hike of this cycle. By the Fed’s own admission, future interest rate increases is uncertain and will depend on incoming data.
In his post FOMC press conference, Chair Powell noted that “events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses”, which could be equivalent to one or more rate hikes, so the Fed may have “less work to do” on monetary policy.
In particular, when asked to explain the change in wording in the FOMC statement from “ongoing increases in the target range will be appropriate” to “some additional policy firming may be appropriate”, Chair Powell emphasized the words “may” and “some” as opposed to “ongoing”.
Reading between the lines, Chair Powell appears to be implicitly saying that the Fed will pause its rate hikes and adopt a wait and see approach, as it does not want to tighten the U.S. economy into a recession.
Markets Expect Fed To Cut Rates In July
In fact, fixed income traders not only expect the Fed to be ‘done’ raising interest rates for this cycle, they have started to price in the Fed aggressively ‘cutting’ interest rates, beginning in July (Figure 2).
Figure 2 – Interest rate traders pricing in rate cuts (CME)
Monetary Expectations Caused US Dollar Pull Back
The sudden shift in monetary policy expectations caused the U.S. Dollar Index (DXY Index) to pull back sharply, falling by 2.3% since it peaked right after Powell’s testimony to Congress (Figure 3).
Figure 3 – U.S. dollar pulled back on changing monetary policy expectations (Seeking Alpha)
The UUP ETF has followed the DXY Index lower, falling by 2.0% in the same time frame.
Two Paths For The Dollar
Looking forward, I see two possible paths for the U.S. dollar and the UUP ETF.
First, there is the ‘soft landing’ scenario, where investors believe a Fed pause and interest rate cuts can arrest the rapidly unfolding banking crisis / credit crunch. If the Fed can avoid a U.S. and global recession, then a ‘dovish’ Fed will lead to weaker U.S. monetary policy vis-à-vis other global central banks, and the U.S. dollar may weaken. This first scenario is shown by the red arrow in Figure 4 below.
Figure 4 – Two possible paths for U.S. dollar (Author created with price chart from stockcharts.com)
On the other hand, I believe there is a ‘hard landing’ scenario, where the Fed is forced to pause and cut interest rates because the banking crisis / global credit crunch is escalating (Green arrow in figure 4 above).
There is an important distinction between the two scenarios, although both involve the Fed pausing and cutting interest rates. In the ‘hard landing’ scenario, there is global contagion from the U.S. regional banking crisis, and the world economy is pushed over the edge and into recession. In this scenario, the U.S. dollar actually becomes the ‘cleanest dirty shirt’, as the U.S. dollar remains the world’s reserve currency, and actually rises in a ‘flight to safety’.
This scenario is not without precedent. Historically, when the world experiences major financial crises, the knee-jerk reaction is to rush to the safety of the U.S. dollar and U.S. treasuries. In figure 5 below, we can see the U.S. dollar index has spiked higher in almost every major economic crisis, from the 1997 Asian Currency Crisis, to the 2001 Dot Com Bust, the 2008 Great Financial Crisis, the 2010/2011 Euro Crisis, the 2015/16 Global Growth Scare, and the 2020 Covid Pandemic.
Figure 5 – U.S. dollar is usually a safe haven asset (Author created with price chart from stockcharts.com)
In fact, we may be seeing signs of credit contagion, as many European banks have seen their credit default swaps (“CDS”) surge in recent days, as investors begin to lose confidence in them following the sudden collapse of Credit Suisse last week (Figure 6).
Figure 6 – European bank CDS surge (Bloomberg)
Weakness in European banks caused the U.S. dollar index to surge 0.6% on Friday, March 24th, 2023, as traders once again rushed to safety (Figure 7).
Figure 7 – U.S. dollar surged on March 24th, 2023 (marketwatch.com)
Hard Landing More Likely
Personally, I believe a ‘hard landing’ scenario is more likely, as I believe the credit crunch from the banking sector will lead to tighter lending standards and increased pressures in the rest of the economy. Already, we are seeing high yield credit spreads widen significantly in the past few weeks, suggesting all is not well (Figure 8).
Figure 8 – High yield credit spreads widen in anticipation of hard landing (St. Louis Fed)
Many real estate investors are also feeling the pressure of higher interest rates and are warning of a ‘hard landing’ in the economy. In fact, parsing the Fed’s Summary of Economic Projections (“SEP”), the Fed itself appears to be projecting a 3-quarter recession beginning in Q2/2023.
Risk From Debt Ceiling
One wrinkle this time around could be the ongoing debt ceiling fight between Democrats and Republicans. If the U.S. government cannot resolve the debt ceiling issue, that could cause a U.S. debt ‘default’ which may lead to weakness in the U.S. dollar.
For now, I believe U.S. politicians will step back from the brink at the 11th hour, like they did in 2011. Let’s hope I am correct to place my faith in them.
Conclusion
With the global economy rapidly hurtling towards a ‘hard landing’ scenario, I believe the U.S. dollar will quickly regain its ‘safe haven’ status and rally in the coming months. Those who believe a ‘soft landing’ scenario is still achievable may take the opposite bet.
