Dunhe: The US dollar is putting downward pressure, A-shares and Hong Kong stocks are expected to rebound from the bottom.

Zhitong App learned that Dunhe Asset Management stated that towards the end of the interest rate hike cycle, the US dollar tends to peak and then decline before US bond yields. The combination of a high interest rate environment and domestic political division is likely to significantly weaken the expansionary fiscal policy in the United States next year, leading to a decline in economic momentum and downward pressure on the US dollar. The recent significant tightening of financial conditions and the breakthrough of the important threshold of 100 in the financial conditions index have also caused the Federal Reserve's stance on monetary policy to gradually shift towards dovishness. The correlation between the US dollar index and A-shares and Hong Kong stocks is higher than that with US bond yields. Once the index starts to trend downward, even if US bond yields do not decline significantly, A-shares and Hong Kong stocks are expected to rebound from the bottom.

Since November, the US dollar index has fallen from around 107, its highest level this year, to 104, reaching a new low since September. Influenced by economic data such as non-farm payrolls and inflation falling below expectations, as well as speeches by Federal Reserve officials, the 10-year US Treasury yield has declined by more than 50 basis points to around 4.5% from its high point this year, becoming the main driver of the US dollar's decline. However, it should be noted that during the previous period of significant increase in US bond yields, the US dollar did not strengthen significantly. In early October, US bond yields reached a new high since the subprime mortgage crisis, and the implied real interest rate of TIPS also reached 2.5%, far higher than the high point of 1.7% in November last year. From the perspective of interest rate differentials, both the nominal and real interest rate differentials between the US and Germany have returned to the high levels of the fourth quarter of last year, with differentials exceeding 200 basis points. However, in contrast to the continuous rise in interest rates, although the US dollar has rebounded since the second half of the year, it has not returned to the level of 110-115 in the fourth quarter of last year. Why did the US dollar show signs of weakness during the period of rising interest rates?

Generally speaking, in the early stages of the Federal Reserve's tightening cycle, US bond yields and the US dollar tend to rise simultaneously, but since 1990, the US dollar has generally peaked and then declined before US bond yields at the end of each interest rate hike cycle. Why does the US dollar peak first? If we understand the exchange rate of a country's currency as the stock price of the entire country, then the driving force behind it is still the country's economic growth. Therefore, the US dollar is more easily influenced by the market's expectations of US economic growth relative to other countries, and it will reflect changes in the economic fundamentals before other assets. The change in US bond yields is not only influenced by fundamental factors, but also encounters supply-side disruptions and the direction of the Federal Reserve's monetary policy. Only when expectations of a shift towards loose monetary policy begin to rise, do US bond yields have the momentum to continue to decline. The change in monetary policy mainly depends on inflation and employment data, and these indicators usually lag behind the economic downturn. Therefore, the turning point of the US dollar often precedes US bond yields. The high probability of the US dollar starting to decline means that the market's expectations of the US economy's relative resilience are beginning to change. In September 2022, the US dollar began to peak and decline, corresponding to the US Markit Composite PMI falling below the 50 boom-bust line in July, while US bond yields did not start to decline from their high point until the end of October.This year, both the nominal GDP and real GDP of the United States have reached a high level not seen since 2000. However, the strong economic growth is clearly diverging from the declining trend in some microeconomic data, such as industrial electricity consumption, which has almost no growth in the first seven months compared to the same period last year, and negative import growth. The core reason for this divergence is the weakness of the manufacturing sector in the United States, while the service sector is recovering rapidly. The Markit Manufacturing PMI in the United States has remained below 50 since the beginning of the year, but the Services PMI has risen above 50 again since February. From the consumption structure of residents, the growth rate of commodity consumption has fallen back to the pre-pandemic average level, while the growth rate of service consumption is still twice the pre-pandemic average. It is worth emphasizing that the service sector is far more important to the US economy than the manufacturing sector. In terms of the industrial structure of the US economy, the value added of the service industry accounts for about 70% of the nominal GDP, while the manufacturing industry accounts for only 10%. In terms of employment impact, the proportion of service industry employees in the current non-agricultural employment population has also reached 72%, while the contribution of the manufacturing industry to US employment is less than 10%. Therefore, this year, the resilience of the US service industry has offset the weakness of the manufacturing industry, and the overall economic performance is relatively stable. In other words, the change in the Services PMI is more critical for judging the turning point of the US dollar. It is precisely because the Services PMI has risen above 50 again this year that the US dollar index has stopped falling and rebounded. So, can the high prosperity of the service industry be maintained? I think it is quite difficult.

In a high interest rate environment, the resilience of the US service industry is mainly due to the continuous expansion of US fiscal policy. The fiscal deficit in the 2023 fiscal year in the United States reached $1.7 trillion, far exceeding the budget deficit of $1.2 trillion in the 2023 fiscal bill and the deficit of $1.4 trillion in the 2022 fiscal year. The unexpected growth of the US fiscal deficit in the first half of the year has led to a continuous rebound in the US Services PMI. However, since July, US fiscal spending has started to decline, and the rolling 12-month fiscal deficit has narrowed. The Markit Services PMI in the United States has also fallen back to around 50. The domestic political division in the United States is likely to make it difficult to maintain a high fiscal deficit next year. The dismissal of Republican Speaker of the House McCarthy reflects the decreasing consensus between the two parties on fiscal spending, and it has reached an irreconcilable level. Some market views believe that the US presidential election next year will lead to Biden continuing to maintain high fiscal spending to stabilize the economy. However, for the Republican Party, opposing additional spending bills in an election year is more likely to affect the election results.

Real estate, as an important part of the service industry, is increasingly affected by high interest rates. The current mortgage interest rate for 30-year mortgages in the United States has risen to 8%, the highest level since 2000. US existing home sales have been weakening since February 2023, with monthly sales falling below four million units, approaching the low point of the subprime crisis. As fiscal stimulus is limited and the counter-cyclical effect of rising interest rates gradually becomes apparent, the Services PMI is likely to fall back into the contraction zone, putting downward pressure on the US dollar.Geopolitical conflicts do not seem to provide more support for the US dollar. Last year, the US dollar significantly strengthened after the outbreak of the Russia-Ukraine conflict, mainly due to the surge in oil prices, which raised energy costs and weakened the competitiveness of European manufacturing. However, since the outbreak of the Israeli-Palestinian conflict, oil prices have actually weakened, and the US involvement in the conflict is far greater than in the Russia-Ukraine conflict. The new round of aid to Ukraine has been put on hold due to limited fiscal expansion, which naturally weakens the US leadership position globally.

The combination of a decline in US stocks and bonds often leads to a significant tightening of financial conditions. Once the financial conditions index (FCI) surpasses the important threshold level of 100, the Federal Reserve's stance on monetary policy will gradually shift towards dovishness, and the US dollar will begin to weaken. Goldman Sachs' FCI consists of five sub-indices: long-term interest rates, credit spreads, exchange rates, stocks, and short-term interest rates. The higher the index, the tighter the financial conditions. Driven by the rise in long-term bond yields and the decline in US stocks, the FCI has surpassed 100 since the end of September, reaching a new high for the year at 100.7, approaching the peak of 100.9 in the fourth quarter of last year. Although US bond yields have fallen since the end of October, major US stock indices have rebounded significantly from their lows, but the FCI remains in the contraction zone above 100. Based on historical experience, once the FCI reaches the threshold of 100 during a rate hike cycle, the Fed's attitude will soften, and the US dollar generally starts to peak and decline thereafter, as seen in December 2018 and September 2022. After the FCI broke through 100, the rhetoric of Federal Reserve officials gradually shifted from hawkish to dovish since October. Some officials believe that policy rates have reached restrictive levels, and the sharp rise in long-term bond yields has itself achieved the effect of further rate hikes.

Compared to US bond yields, the US dollar index is more forward-looking and better represents the flow of funds in the global market. Therefore, the US dollar index has a higher correlation with A-shares and Hong Kong stocks than US bond yields. After the ratio of foreign holdings of A-shares to the total market value exceeded 1% in 2017, the direction of the US dollar index has been basically consistent with the risk premium of A-shares. For example, in the fourth quarter of 2017, while US bond yields fluctuated upward to nearly 3%, the US dollar index continued to decline to below 90. During this period, A-shares and Hong Kong stocks showed an upward trend, with the Shanghai and Shenzhen 300 Index and the Hang Seng Index rising by as much as 14% and 20% respectively, until the US dollar index bottomed out in January 2018. Since late July this year, during the period of the US dollar index strengthening, a net outflow of over 170 billion yuan has been recorded through northbound trading. Once the US dollar index starts to trend downward, even if US bond yields do not significantly decline (US bond yields generally do not rise significantly during the US dollar's downward phase), A-shares and Hong Kong stocks are expected to rebound under the global liquidity push.