The Dollar Strengthening against Most Assets: What is Hiding behind the Scenes?

The U.S. dollar is one single name factoring current broad asset classes’ counterintuitive downfall against the rising inflationary expectations. Yesterday the U.S. Dollar Index, DXY, jumped to a three-month high while advancing for the third straight session as corresponding long positions skyrocketed underpinned by hawkish signals from the U.S. Federal Reserve and growing possibility of new Covid lockdowns related to spikes of the vicious Delta variant.

Notably, DXY traded in close proximity to its game changing 93.00 mark, up 3.73% from the May low of 89.53. The move is even more surprising given decreasing U.S. yields, with the 10-year note hovering around the 1.25% level so far.

The net long positions show dollar index net longs picked up more ground reaching their highest level since May 2020. The USD has also gained against its major counterparts, rising 0.42% against the British pound and 0.22% against the euro.

Flight to safety is hardly something new for experienced investors, however, such episodes tend to accumulate their quantities leading to change of quality, i.e. they come at a price. Until the mid-2000s, a harmoniously complementary financial model existed between the United States and Europe. Prices in Europe were higher than ones in the U.S. The dollar was weaker than the British pound, and in terms of purchasing power parity it was weaker than the euro (in the past – Deutschemark and both Francs), inflation was higher, interest rates in dollars were higher than in European currencies. Synergy of those factors had been safeguarding a solid, mostly unidirectional, positive capital flows, as well as shopping traffic from Europe towards the States, which proceeds the latter used to selectively “export” back to Europe in the form of the U.S. high margin investments that counted towards the U.S. GDP.

This model could have existed for decades, and thanks to it, the United States would be a completely different economy today! However, since USD started experiencing episodic jumps disconnected from the fundamental factors of the U.S. economy known as “flights to quality”, the whole perfect picture irreversibly changed: while U.S. inflation is still higher than one in Europe, interest rates in Europe (taking into account all member nations of the European Union) are also conditionally higher (although not much) than in the States, and prices in Europe are now in purchasing power parity lower than in the States (and in general, now many consumers mail-order stuff from China stripping both the U.S. and European vendors from their profits). As a result, the gear for exporting dollar investments and transatlantic shopping is broken. Europe economically and financially continues to move away from the States, and the States in this scheme increase the amount of capital not thanks to its exports, but due to the Fed’s printing machine.