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The smiling dollar

2013 has seen a seismic shift in correlations in the global currency markets.

For more than a decade, the US dollar was the ultimate counter-cyclical asset, negatively correlated to risk appetites/global growth (though a clear safe haven during times of financial stress, such as the post Lehman banking crisis in 2008 and the Greek sovereign debt debacle in 2010). Yet no more. The US dollar was positively leveraged to “irrational exuberance” on Wall Street last week as the Dow and S&P 500 index hit successive highs. The past decade’s core themes were the emergence of China as an economic superpower and an almost eight-fold rise in crude oil prices. These were both negative for the dollar since US exports to China are minimal relative to GDP and oil prices were inflated by the easy money policies of the Greenspan/Bernanke Fed as well as the parabolic growth in Chinese energy demand. The wars in Afghanistan and Iraq were also a trillion-dollar sword of Damocles on US trade deficit and, ceteris paribus, a negative overhang on the US dollar.

However, the world has changed in 2013, as it has a predictable tendency to do so ever since the beginning of recorded time. The correlation between oil prices and the dollar has fallen since 2008, a testament to the shale oil/fracturing revolution that finally promises US energy independence. Obama’s entire foreign policy focus is to exit the protracted wars in Iraq and Afghanistan. China’s Politburo has pledged to move its growth ballast from exports to domestic consumption. These three macro events, in my view, midwifed 2013’s bull market in the greenback, though Abenomics, the Italian election, and the ECB/Bundesbank splits and the fact that US oil imports have fallen to 1992 levels were also all catalysts for the dollar bid. These macro themes will be a game changer in international finance in the next few years, with profound implications for both investment strategy and geopolitics. The dollar’s smirk is now a smile!

The future of the US dollar could lie as much in the shale oil fields of North Dakota and Texas’s Permian Basin than in the monetary conclaves of the Federal Reserve or the fiscal battles on Capitol Hill. Thanks to a surge in US natural gas/oil production, the US current account deficit is now 2.8 per cent, its levels under the Clinton era (a time when the post-Gulf war Pentagon was also downsizing its global military empire). Wall Street’s money centre banks are among the best capitalised in the world, as the recent Fed stress tests demonstrate. Europe’s banking risk and petroleum trade deficit metrics are deteriorating dangerously fast relative to the US. Hence the paradoxical fall in the euro even while LTRO replacements shrank the ECB balance sheet and Irish debt yields fell below Italy/Spain.

Despite the CBO’s estimate of a 0.5 per cent fiscal drag due to the sequester, the black gold bonanza in the US means a boost to US economic growth, as the natural gas plunge is a steroid shot for US consumer spending, 70 per cent of GDP. This, in turn, reduces the inflation risk premium in US assets since it raises the growth potential in the business cycle. If Obama and the Republicans finally agree on a budget deal, King Dollar has emerged as one of the world’s best-performing currencies in 2013. If my King Dollar thesis is right, the Singapore dollar’s epic bull market (flagged here way back in 2005 when the Sing was 1.68) is now over, as its correlation with the yen and Chinese capital flows rises. The euro-dollar has a lot more downside in the next two years and the Elysee Palace will get its wish, thanks to North Dakota, not Frankfurt!