The Return of King Dollar

King dollar is back.  For the last decade, the dollar has generally been inversely correlated to the S&P 500.  When markets were up, the dollar was down versus most other currencies.  Higher markets were associated with lower volatility and greater risk appetite – the “Risk On” trade.  Investors would short dollars and buy higher yielding currencies like the Australian Dollar, Brazilian Real and Norwegian Krone.  On a risk-adjusted basis, these carry trades had an attractive Sharpe ratio and were the lifeblood of too many hedge fund managers (collecting 2/20 on carry is almost criminal, but that’s another story).

It’s good to be the king, while it lasts…

This year, however, the dollar changed course.  It began to rally with the market, and rally without it.

Source: BBG

There are three reasons for this reversal in dollar behavior.  First, the US is growing, while the rest of the developed world is not.  That is attracting flows into the US, supporting the dollar at the expense of European and Asian currencies.

Europe and Japan are going in the wrong direction; Source: BBG

Second, rates in the US are rising and currently higher than the other developed markets.  As rates rise, the yield differential between US and other currencies shrinks – or inverts – making the dollar the beneficiary of carry trades.

Source: BBG

Third, volatility in the foreign exchange market has risen.  This has driven the unwinding of short dollar trades.  Imagine that you earn 4% per annum selling US dollars and buying Brazilian Real.  Now imagine the volatility of that cross is 8%.  That’s a Sharpe ratio of 0.5 – respectable in most circles (but again, not worth paying 2/20 for…).  Now imagine volatility doubles.  The Sharpe ratio is only 0.25 – better than many active managers (benchmark adjusted) but not a great risk/reward.  Higher volatility means carry trades get cleaned out, and money coming back to dollars pushes the greenback higher.

What does this all mean?  It’s been a very long time since the dollar behaved this way, and it has most market participants confused.  We see a robust USD against the QE-fueled Japanese Yen, commodity currencies like the Australian dollar and traditional high carry currencies like the Indian Rupee and South African Rand.  If the world starts growing, output gaps drop and rates rise outside of the US, the dollar will revert to its old ways.  Until then, it’s good to be king.