March 18, 2015
Towards the summer of 2014, the US Dollar, measured against a trade-weighted basket of currencies, started to rally. Fast-forward 9 months and this move has become parabolic, with US currency trades at a 12-year high and on course to record its best quarterly return since 1992. Part of this strength is attributable to the weakness of two of the US’s main trading partners – Japan and Europe. Both the Bank of Japan and the European Central Bank are in the midst of a massive-scale money printing program, a combined $120bn-a-month exercise, whose goal is to stimulate growth and boost exports through the depreciation of their own currency. In contrast, the US Federal Reserve has indicated that it might be considering an increase in interest rates, thus making dollar-denominated assets relatively and increasingly attractive.
Yet at 0.24% for one year, the yield on US government bonds is hardly mouth-watering. But in a world flirting with deflation this is almost as good as it gets for a safe asset since, according to JPMorgan, approximately 16% of global government bonds with maturity higher than 1 year trade at a negative yield. Buy a Danish or a Swiss bond and you are sure to get less than what you paid for when they mature. From a currency standpoint, American assets are therefore attractive. However, since a strong Dollar is an impediment to the competitiveness of US businesses, investors have reduced their US holdings mostly in favour of European assets. According to Merrill Lynch, the cumulative flow out of US equities has amounted to $50bn so far this year. Unsurprisingly, European equities have outperformed US equities by no less than 16 percentage points in 2015.
This rationale makes sense on paper, but as Thomas Huxley, a British biologist contemporary of Darwin once said – “the great tragedy of Science is the slaying of a beautiful hypothesis by an ugly fact”. This holds true for the hypothesis where a strong US Dollar is bad for US equities since a simple regression of monthly US stock returns against the performance of the US Dollar since 1980 shows that American equities trade completely independent to the performance of the Dollar. While it is true that the recent past (the last 3 to 5 years) shows a degree of negative correlation, two time series can be strongly negatively correlated while evolving in the same direction. This is what has happened to the USD and US equities – they have both gone up. In another exercise, we observed the average annual performance of US equities against that of the US Dollar by quintile and see results that are completely consistent with previous findings.
MONOGRAM CAPITAL MANAGEMENT