As mentioned earlier, we estimate that the dollar is more than 20% expensive to PPP currently.

Adjusting for terms of trade, productivity and real rate differentials in a BEER framework, it is still more than 1 standard deviation, or about 10-15%, expensive.

As mentioned previously, this dollar overvaluation can be seen as a risk premium over three macro impulses: a) from slowing Chinese demand amid zero-COVID policies and tight property market regulations; b) from the ongoing war in Ukraine and the risk to European energy security it continues to pose; and c) from overextended US domestic demand and the potential for a substantial Fed overshoot and hard landing there.

We use market variables to create a proxy for each of the above shocks. To capture these, we use the first principal component of market variables sensitive to growth in each region (US: cyclical stocks/SPX, 5y5y real yield; Europe: 5y5y real yield, 10y BTP-Bund spread, Eurostoxx; China: copper, USDCNY and A-share). We regress weekly EURUSD returns against the three regional factors using a 10-year sample.

We find that between the US impulse to the dollar and the China impulse, one can explain the entire 4+% drop since 11 March. Interestingly, the negative growth shock has likely offset part of the policy impulse mostly in Europe but to some extent also among US proxy variables, ultimately limiting the net effect on the currency as well. It has left China, where the shock has been quite directional either way, the key driver.

Overall, the recovery and COVID trends in China can play a key and underappreciated role in driving the dollar in the background.

Long term, our economics views imply that the dollar should weaken

Given our Economics team’s base case, there is a reasonable chance that – over time – some of the current pressures are set to moderate.

Specifically, our China economist expects a very gradual but very steady improvement in output over the next 12 months. In essence, while the recovery may take some time to play out in full, and while growth may undershoot the consensus, we think the worst is over in terms of Chinese activity.

Our US economists expect some moderation across US growth and inflation. Indeed, initial claims point to a moderation in the pace of the labour market expansion; mortgage applications point to further slowing in new and existing home sales; while inventories for goods, outside cars, seem to have increased greatly (Figure 11). Zillow rents, meanwhile, point to moderating shelter inflation (Figure 12), and used car prices may start to decline once inventories rebuild.

Last, while our European economists expect a technical recession in Q4 this year, they also expect the European economy to digest relevant shocks and re-accelerate thereafter.

Convergence in output and real policy rates may happen slowly, but they are bound, in our base case, to take place, reducing the need for dollar overvaluation.

This is why, in our 12-month views, we assume some convergence towards USD fair value and, as a result, some depreciation for the greenback, by 5% vs current levels.

But here and now, to sell USD is to underwrite large and likely tail risks

Beyond the base case, however, we have increasingly become worried that the persistent or even increasing risk of large tail events may force the dollar deeper into overvaluation territory in the near term and have revised our forecasts recently for that reason. Two main developments have shaken us from our original views in terms of levels and timing for the dollar peak:

• First, we critically assumed that China would use the Shanghai and Beijing breakouts to engage in rapid vaccinations and termed-out yet permanent re-opening policies. Yet the most recent politburo meetings only affirmed the determination to keep zero-COVID policies in place. The timing of the Beidaihe meetings and the subsequent congress allows little room to expect that – during the winter time – COVID policies can be meaningfully relaxed.

The prospect of rolling lockdowns in China acutely raises the stakes for a deeper output crisis there. This is because, at the moment, China is in as much economic distress as we have ever seen. Unemployment rates are high and rising; property markets are in secular decline, with few developers bidding for land, prices falling and inventories rising (see Figure 13 and Figure 14); while domestic absorption seems largely stagnant (see Figure 15).

Indicative of the lack of demand, the level of credit extended to the economy year-to-date is quite a bit below prior years (see Figure 16), despite the easing of policies and the efforts of the authorities to stimulate the economy.

• Second, despite being generally bullish on commodities and commodity currencies, the upside skew to energy prices (and the potential knock-on effects across commodities and goods) is starting to look a lot more worrisome than before. More specifically, it has been remarkable how little pickup there has been in oil inventories during the China lockdown, which is indicative of the supply imbalances in place. This shows just how little space there is for any disruption in oil supply going forward.

And it is not just Russia that may trigger further tightness in oil markets; crucially we continue to monitor increasing tensions in the Middle East owing to higher food prices, a reduced Russian presence in Syria, Turkish political risks and the ongoing intensification in tensions between Israel and Iran.

A quick regression that links oil production vs demand imbalances to prices (see Figure 17), taking into account non-linear effects at the time of extreme shortages, shows that a 2 standard deviation shift in the oil demand/supply balance (about 2mn barrels daily worth of a disruption) could take oil prices, on average, up to $140/b (with the prospect of an overshoot to the average around the time of the disruption).

The combination of those two factors would trigger acute risks of central banks tightening amid increasing cyclical shortfalls. Such risks would be more intensely felt in more open economies that are more directly exposed to energy supply risks in CEMEA and Asia.

Of course, the US economy would also be affected. Yet the starting point for the US economy is an already very positive and stretched output gap (see Figure 18). Growth softness only moderates the degree to which the Fed will need to engineer a slowdown but not change the direction of travel for policy.

In contrast, the output gaps across a large set of CEMEA and Asian economies are still negative.

Tighter policy and weaker China growth would derail the closure of the output gaps and present medium-term dilemmas for central banks.

Symmetrically, if China’s recovery gained pace beyond our forecasts or if there were a ceasefire between Russia and Ukraine, some of the clear risks would abate, leading the USD to a “relief sell-off” closer to fair value.

What is the dollar upside in a tail event?

So how much can the dollar move if a tail event, such as the one we describe above, were to take place? We follow two stylized approaches. In the first one, we allow the dollar to drift to 2 standard deviations of overvaluation using the two fair value models we described above. In the second one, we shock our model of regional growth impulses by 2 standard deviations for the US, Europe and China alike (over a month).

In both cases, we find that over a short time span of about a month or less, the dollar can drift c.3% stronger, basically towards parity.

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Houses and Holes

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.

He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.

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