Rally in risk to weigh on dollar

The surge in risk assets at the end of last week has helped to take some of the fizz out of the US dollar’s year-to-date rally with the DXY index giving up more than 0.5% on February 5^th alone, its largest single day decline since mid-December. Markets have been balancing the optimism around the rollout of Covid-19 vaccines against mixed data that has been coming out of major economies with the net result being gains for the dollar index so far this year, up by 1.2% ytd as of February 5th.

A decisive risk-on rally could temper the dollar’s gains particularly as its negative correlation to moves in risk assets remains steady. Since mid-2020 the dollar has been a reasonably strong way to express a risk-off view, gaining during intermittent bouts of weakness in equities and vice versa sliding as markets responded to extensive central bank accommodation and economic recovery.

DXY vs S&P 500

Source: Bloomberg, Emirates NBD Research. Note: rebased to Jan 1 2020 = 100.

Until last week the response by risk assets (defined here as equities, high-yield bonds, commodities) to vaccination drives and improving economic outlooks had been tentative. Equity markets have been fluctuating between ytd gains and losses but the rally last week—the S&P 500 gained almost 4.65% while the MSCI World index was up almost 4.2%—looks a little more surefooted. Better than expected corporate earnings for Q4 are reinforcing a view that 2021 may indeed end up stronger than the first few weeks of Covid-19 related restrictions would seem to imply. Oil prices have seen a sustained rally to their highest levels in the past year but largely down to supply curtailment from OPEC+ and other producers.

Dollar has been the consistent performer this year

Source: Bloomberg, Emirates NBD Research.

Expectation that the Biden administration will be able to pass a substantial stimulus and support package by the end of Q1 will likely also invigorate risk assets and push back against the dollar although we expect the next several weeks to be highly headline driven, with the potential for dissent among moderate Democrats threatening to derail the spending plans.

The greenback’s strength among majors so far this year has not been absolute but has been seemingly concentrated against countries where the rollout of Covid-19 vaccines has been limited or hasn’t yet begun. Sterling has been the notable outperformer among major pairs against the dollar, gaining 0.5% ytd as of Feb 5. The UK has managed to successfully administer vaccines on a wide scale, with nearing on 20 doses/100 people as of early February. By contrast EUR, JPY and CHF have all seen considerable ytd losses against the dollar while vaccination rates have been minimal, or in Japan’s case have yet to even begin.

Vaccine roll out: leaders and laggards

Source: Bloomberg, Our World in Data, Emirates NBD Research

We outlined previously that growth differentials, rather than rate differentials, are likely to be the major determining factor for currency markets this year and we still expect that to be true. The Fed, ECB, BoE and BoJ have all kept policy on hold at their first meetings for 2021 while individually trying to talk up the prospect of respective recoveries in their economies in the second half of the year. When those recoveries can begin in full will largely be a dynamic of public health and vaccine rollouts—for example, persistent lockdowns in Germany or extensions of emergency conditions in Japan would seem to weigh against any near term recovery in their economies.

While the US is by no means out of the woods in terms of returning to full economic health—January’s disappointing nonfarm payrolls is a case in point—the combination of a relatively effective vaccine rollout and heavy spending plans are setting up the potential for a robust rebound this year. While the current relationship between risk assets and the dollar would imply that a strong rebound would signal more downside for the greenback, the negative correlation between the two is not static. In data going back to 2000, periods of positive and negative correlation between daily returns for the dollar and risk assets have been nearly equal, at least on a 100-day rolling basis. A sustained pull higher in UST yields could see the current negative correlation flip and see a tandem move upward in the dollar and risk assets.