The Counterintuitive Nature Of The US Dollar

The US dollar is an extremely important early indicator of global economic activity. The amount of information that goes into the cross rate between different currencies is all-encompassing. 

When discussing the US dollar, however, it is important to specify between major currencies and emerging market currencies as the information in those cross rates is quite different. 

The US dollar and the Euro can trade based on relative growth differentials, relative changes in interest rate differentials and generally rise or fall based on the relative strength between those two economies. 

When discussing emerging market currencies, however, the relationship can be counterintuitive. 

If the US economy slows sharply, the dollar will likely strengthen against emerging market currencies which is why a pronounced weakness in EM currencies or strength in the US dollar relative to EM currencies is one of the earliest indicators in economics. 

US Dollar Bullish ETF (UUP) / Emerging Market Currencies (CEW):Source: YCharts, EPB Macro Research

Emerging market economies are very reliant on exports to obtain US dollars. While each economy has its own currency, the strength of that currency is largely dependent on the position of FX reserves or the number of dollars a country can use to support their currency. 

If US demand slows, and exports then drop, the emerging market economy will have fewer dollars flowing into the economy and thus a worse FX reserve position. 

Other factors play into this equation such as rising interest rates and the global dollar liquidity but for now, let's look at the global economic cycle through the lens of emerging market currencies. 

The chart below shows the trade-weighted US dollar index for major currencies and for a broad basket of currencies. The difference should be noticeable as the broad index is up 33% since 1994 but the major index is up just 6%. 

The US dollar relative to major currencies and emerging market currencies are very different so we need to specify what we are looking at. Most analysts just use the DXY index which has a 58% weighting in the Euro, a 14% weighting to the Yen and a 12% weighting to the Pound. 85% of the index is in three major currencies which can be useful, but not for measuring the broad strength of the dollar. 

US Dollar Trade Weighted Index - Broad Basket:Source: Bloomberg

Below is the JPMorgan Emerging Market Currency Index and I have broken the chart down into three time periods. When the index is moving higher, the dollar is getting weaker relative to EM currencies and when the index is moving lower the dollar is getting stronger. 

A strengthening dollar relative to EM currencies, while not 100% accurate like any indicator, can often be the earliest signal of weakening global economic trends. 

Preceding the January 2016 market crash, emerging market currencies weakened dramatically before bottoming in December of 2015, two months before the stock market bottomed and eight months before the economic cycle officially turned higher. 

EM currencies rallied throughout the global economic recovery as we'd expect. World trade picks up which benefits EM exporting nations. 

JPMorgan Emerging Market Currency Index:Source: Bloomberg

In January of 2018, EM currencies started to dive lower again. EM currencies started to gain strength very early, in October of 2018 as a result of the pivot from the Fed, moving from more QT and three rate hikes to likely ending QT and zero rate hikes. This change certainly impacted world dollar liquidity and helped EM currencies which was reflected very quickly. 

Over the past three weeks, EM currencies have started to drift lower again. 

The dynamics in the EM currency space are critical to watch. If the October bottom was the official bottom in EM currencies, that is a very bullish sign for overall growth. If this move in EM currencies is just a bounce within a longer-term downtrend, that is a negative sign for global growth. 

A sharp move lower in EM currencies (strength in the dollar) would be one of the earliest indicators that the world economy is taking a leg lower while pronounced EM currency strength would be very positive for the global rebound story.

While counterintuitive, rapid dollar strength against EM currencies could be signal that the US economy is slowing (fewer exports for EM nations).