The yield curve inversion as a leading indicator of recessions

The medium and long-term outlook for the US Dollar

Date: 09 December 2018

The USD is a very important macro driver for multiple asset classes and for US corporate profits. The future direction of the USD is therefore
an important input parameter into asset allocation and portfolio decisions. The USD has been in a bull market for 7-10 years now, depending
on which currency it is measured against. What’s next?

Economic growth: The chart below shows the trade-weighted USD (major currencies) against the ratio of US GDP/World GDP. The blue bars
show the historical ratio, while the orange bars are future projections of the ratio (source: World Bank, IMF, knoema.com).

It is obvious that this a close relationship. When the US economy outperforms, the USD strengthens. When the US economy shrinks as a
percentage of the world economy, the USD drops. “Shrinks” doesn’t necessarily imply recessionary conditions. Shrinkage can happen when
other economies rise faster in a global reflationary cycle. Based on the ratio’s forecast, we expect a weaker dollar for the next five years.
In fact the USD may have peaked at the end of 2016 against some developed currencies, in-line with the ratio’s peak.

Interest rates: The USD’s rise since 2013 has been supported by interest rate differentials, which widened during the FED’s rate hiking cycle,
while other Central Banks continued to pursue easy policies (ECB and BOJ). The chart below shows that the spread between UST 10yr and
Germany’s 10yr bund is at a 30yr high. But as per our previous reports (Eurodollar curve inversion-10 Nov 2018 and Yield curve inversions,
recessions & stock market peaks-30 Nov 2018), we expect a pause in the FED’s tightening cycle soon and a rate cut cycle to start soon,
probably in 2019. The table below shows how the trade weighted USD reacted when the FED started an easing cycle in the past.

Date of start Date of Difference DXY USD drop Duration of Recession

of FED easing USD peak in months % drop duration (m) FED easing (m)
Jul-89 Jun-89 -1 -25% 39 42 YES
Jul-95 Dec-94 -7 -10% 5 7 NO
Oct-98 Aug-98 -2 -10% 2 3 NO
Dec-00 Jul-01 7 (1) -30% 30 31 YES
Aug-07 Jan-07 -7 -16% 15 (2) 7 (2) YES
Negative me ans
USD pea ke d fi rst
1. There was a USD peak in Oct 2000, followed by a quick one month drop of 8%
2. Once the 2008 crisis became acute, after Aug 2008, the USD rallied on safe haven flows. However,if we include
QE1 and QE2 in the easing cycle, until 2011, the drop of the USD was 15% and lasted 51 months

Observations from the table:

1. In all cases the USD dropped. The drop was between 10% and 30% from the nearest peak. The average drop was 18%.
2. The USD drop started before the easing cycle commenced, by up to 7 months. Even in 2000, there was a USD peak before the easing cycle
started, although the ultimate USD peak came later.
3. The duration of the drop nearly matched the duration of the easing cycle. During recessions, the duration was much longer, at least 2.5
years long.
4. The magnitude of the USD drop was larger during US recessions, with a range of 16% to 30%.
Based on our outlook for monetary policy, a weaker USD is expected going forward. If we have a recession, the drop could be deeper
and last longer.

Valuation is not supportive of the USD either. This is probably expected after such a long bull market. We have used purchasing power
parity (PPP) data from the OECD for this part of the analysis. The charts at the Appendix (next page, bottom) show PPP relative valuation
between the USD and JPY, EUR, CAD and GBP. These currencies add up to a 92% weight of the DXY trade-weighted USD. Except for the
CAD, the other currencies are near the bottom of their 30yr valuation range against the USD. The weighted average overvaluation of the USD
is currently about 11%. This is similar to the 10% overvaluation of the USD against the same currencies in 2001, which was the last long-term
bull market peak of the USD. Between 2001 and 2007/08, the DXY fell by nearly 40%, reaching a 20% undervaluation.

Cycles: The USD seems to be following a repetitive long-term cycle which lasts about 17 years. It is the third time that it’s tracking this 17yr
cycle and all three instances are shown in the chart below. The cycles are: 1974-1990, 1991-2007 and 2008-2024. They are all aligned to show
the three periods of USD price action: range bound (6yr duration), USD bull market (5yr duration) and USD drop (6yr duration).
Some observations from the chart:
1. The prior two cycles tracked each other very closely. The current cycle also tracked the pattern for 9 years but seems to be diverging
in 2017/18, hinting either at a weaker USD, or at a different outcome than the cycle would imply. However, if we plotted the broad
trade weighted USD, we would see that a new USD bull market high was reached recently for this cycle, indicating maybe that the
cycle is still tracking, although not against major currencies.
2. Each cycle has lower values of the USD, by an average of 15% lower from the previous one.
3. According to the analogue, a sustained USD drop may start in 2019. The majority of the drop may be observed in the first 3yr period
of 2019-2021, as in prior episodes. The case for a USD peak soon would align with our expectations for interest rate policy. It is
possible that the initial drop could last for 3yrs if we also have a recession, as indicated by the table in the previous page. If the
analogue continues, the overall drop may last until 2024, and even after that, if the range bound period ensues, the USD may stabilize
but stay at low levels until the end of the 2020s decade. This would imply a weaker USD for a full ten year period.

Discussion and conclusions:

A weaker USD is expected going forward, possibly for quite a long time. This view is supported by forecasts for US GDP growth relative
to the world, high relative USD valuation, outlook for easy monetary policy and long-term cycles. We have not discussed other factors, such as
rising US debt levels, current account and budget deficits, trade wars, diversification of global central banks holdings, or even attempts to
bypass the USD for global transactions. Although these could also be valid points to consider, they are not supported by any data yet. Instead
we have elected to analyze the outlook for monetary policy, historical data, available forecasts and past cycles to arrive at our conclusion.
Regarding the long-term cycle, we realize that things may turn out differently this time. However they also may not, in which case we may
be entering a period of USD weakness with much lower prices than expected or experienced before, and for much longer than
imagined. We think it is useful to have this possibility under consideration and plan accordingly.
A weaker USD outlook creates opportunities for investment policy and asset allocation. We will cover some ideas in the next reports.

Appendix:
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