An unusual anomaly arose during the latest banking crisis when a long-standing historical relationship broke apart. When bank stocks skidded in response to the problems that first appeared at Silicon Valley Bank, the 2-year Treasury yield fell dramatically, indicating a rush for the safety of Treasury assets. What was unusual this time was the weakness in the USD. The greenback has rallied during past financial scares and crises as investors piled into the safety of the USD and Treasury paper. This time, Treasuries did reflect a flight to safety, but not the USD. As the USD has been inversely correlated to the S&P 500, and the dollar can’t advance even with the macro tailwind of a banking crisis, what does this mean for asset returns?
The long-term picture
Let’s start with the long-term view. The 20-year chart of the USD shows that it has retreated to test a support zone that stretches back to 2015. If it were to break support – the next support level can be found at just under 90 – it would spark a secular bear phase and the dollar could face considerable downside potential compared to current levels.
What would a break of support mean for asset prices in the next market cycle? While correlation isn’t causation, the relative performance of the S&P 500 against MSCI EAFE has been highly correlated to the USD Index. Will dollar weakness mean better relative returns for non-U.S. equities?
To be sure, the relative forward P/E valuation of different regions argue against U.S. equities.
If the USD were to fall into a secular bear phase, one asset that is likely to benefit is gold, which has historically been inversely correlated to the dollar. Gold prices staged an upside breakout from a multi-year base in 2020. If the greenback were to weaken further here, it would represent further tailwinds for the yellow metal.
The measured upside on a monthly point and figure chart of gold is $2,779, though that represents a multi-year target and it’s unlikely to be reached in the immediate future.
A cyclical Warning
One word of warning. There is one negatively correlated asset to the USD that is flashing a cyclical warning. In addition to gold, commodity prices have also been historically inversely correlated to the dollar. But the two assets started to diverge in mid-2021.
I attribute this to a sign of global cyclical weakness. The decline in the cyclically sensitive copper/gold and base metals/gold ratios is a sign of economic weakness. Economic weakness is also foreshadowing a reduction in risk appetite, as measured by the stock/bond ratio.
A similar relationship can be found between the copper/gold ratio and the 10-year Treasury yield. Weakness in cyclical indicators like copper/gold point to lower bond yields and a probable recession ahead.
In conclusion, the USD Index is on the verge of breaking long-term support. If it does, it would have multiple implications for asset class returns:
- Bullish: Non-U.S. compared to U.S. equities.
- Bullish: Gold.
- Bearish: Near-term economic outlook. Commodity prices are sounding a warning that a recession is likely ahead, which would be bullish for Treasuries and bearish for cyclically sensitive assets like commodities.