US economic surprise indices are sitting at the highest levels since 2020 as incoming data keeps topping forecasts, defying expectations for a policy-induced slowdown. Upheaval in the US banking sector seems to have ended without inflicting lasting damage on lending conditions. Consumer demand remains remarkably robust. Core inflation is still high. Labour markets are hot. Financial conditions are accommodative, and asset prices are melting up.
Yet after a record-breaking 11-year bull run, the greenback remains well below its September peak, and selling pressure has accelerated since mid-July’s softer-than-anticipated inflation print led markets to assume an imminent end to the Federal Reserve’s tightening cycle.

Market participants expect yield differentials to narrow in the latter half of the year, with slowing growth and inflation rates supporting a more dovish monetary policy outlook in the US, even as central banks in Europe, the United Kingdom, and Japan remain in inflation-fighting mode. Relative rates are seen turning even less supportive in the years ahead, when the Fed is expected to cut far more aggressively than its peers.

Market-implied change in central bank policy rates, %

According to the precepts of Stephen Jen’s “dollar smile” theory, the greenback tends to rise in value during periods of extreme economic performance – on both ends of the spectrum – and fall in value during periods when the US is growing more slowly than its global counterparts. It seems that just such a “muddle through” scenario is set to unfold, with all of the major components of domestic demand showing signs of exhaustion after an outsized post-pandemic recovery.

Fiscal policy at the state and local levels is still providing unexpected stability, and aggregate incomes are rising more quickly than inflation – providing the fuel for continued strength in consumer spending and real estate market activity. But as higher financing costs bite, homebuilding activity is stabilizing at lower levels. High-frequency data suggests consumer spending is beginning to fall as excess savings held by lower-income households – those with the greatest marginal propensity to spend – evaporate and are replaced with new debt. With delinquency rates pushing higher and student-loan forbearance programs set to end in September, headwinds are building for investment, inventory accumulation, and corporate profit margins.
Perhaps most importantly, recent data releases point to a softening in labour market conditions, with benefit claims rising, job openings falling, wage growth slowing, and hiring volumes reverting toward normal replacement levels. We expect most major sectors in the US to be showing signs of strain by the end of the third quarter, putting the conditions in place for a short-lived narrowing in global growth gaps.

Job openings and unemployed, total, thousands, seasonally adjusted

In the aftermath of the 2008 global financial crisis, households and businesses in the United States deleveraged, and have thus far managed to keep debt levels relatively restrained. In contrast, private sector leverage has risen spectacularly – in both absolute and momentum terms – in countries like Australia, Canada, South Korea, and France, and in smaller economies like Denmark, Norway, and Sweden. In China, decades of unproductive investment and unrestrained credit creation have left policymakers struggling to manage ballooning debt burdens across the financial system.

If global liquidity conditions worsen and borrowing costs remain stubbornly elevated, we suspect these vulnerabilities could upend post-2000 currency market dynamics. Central banks in over-indebted developed-market economies could be forced into cutting rates more dramatically than the Fed as increasingly-constrained households cut spending and businesses slash investment. With authorities in China working to provide stimulus while avoiding a melt-up in property markets, commodity demand might remain relatively subdued – particularly in comparison with the 2009 episode – contributing to a slowdown in major emerging market economies.

Total credit to private non-financial sector, % share of gross domestic product, Q1 2000 – Q4 2022

The greenback remains deeply overvalued against the euro, pound, and yen. We think the correction that began last year will continue to unfold over the next 12 months, with the trade-weighted exchange rate underperforming relative to the world’s biggest economies.

But we don’t expect this decline to prove as fast-paced or as sustained as the consensus would suggest. We’re not convinced the Fed will cut rates before May 2024, and we think long-term yields could remain remain relatively elevated as liquidity ebbs and quantitative tightening efforts continue. This could mean that the dollar maintains positive real carry relative to currencies like the yen, euro, and Chinese renminbi.. Renewed financial turbulence could increase the currency’s safe-haven appeal, and from our perspective, the key factors that have driven secular dollar depreciation cycles in the past – falling short-term yields in the US and relative outperformance in other parts of the global economy – simply aren’t likely to follow long-standing patterns.

Trade-Weighted Dollar Indices