That’s why one hedge fund trader says a stronger dollar could lead to higher-than-expected US inflation

Gang Hu, a 20-year veteran trader at New York hedge fund WinShore Capital, warns that a sustained rise in the US dollar could lead to higher-than-expected US inflation, a counterintuitive view that’s not widely shared.

If Hu’s scenario plays out, it would reverse the script of the more traditional notion that a stronger dollar curbs inflation by dampening demand and lowering import prices. The dollar has been on the up for over a year, benefiting from its safe haven appeal, expectations of higher US interest rates and a view that the US economy should fare better than other parts of the world.

One of the biggest unknowns of the COVID-19 pandemic is how long persistently high inflation will persist in the US and around the world. Financial markets braced themselves for the prospect of a more stagflationary outcome in the US this week, with stock selling, rising yields and the ICE US Dollar Index DXY,
reaching one of the highest levels in 20 years. Most traders are not yet positioned for an environment where inflation either continues to rise or does not fall significantly by next year.

“I think I’m very lonely,” Hu, 49, said by phone on Friday. “But it really boils down to whether inflation expectations are coming off the anchor, and I sense that they are.”

When expectations are anchored, a stronger dollar is viewed as a deflationary force as companies focus on deteriorating demand and can lower prices quickly. But when they dissipate, those expectations result in “more people believing in inflation and more people feeling free to raise or accept higher prices,” he says.

The chart below shows how the US dollar index has risen in line with the 10-year break-even rate, according to Hu.

Source: Bloomberg LP

Hu recognizes three different possible interpretations for this dynamic. One is that inflation drives the dollar higher; In other words, the strength of the US currency simply reflects the need for policymakers to raise US interest rates and stamp out inflation. The second is the view that the movements are purely random. And the third he calls “a bit controversial”.

It’s the idea that the stronger dollar outside the US could “signal future market disruption” and push inflation higher than financial experts believe. His logic is as follows: A stronger dollar tends to do most harm to non-US investors and corporations, increasing the dollar-denominated liabilities of foreign non-banks while also acting as a potentially negative force on non-US corporate balance sheets. Most economists can agree on that.

What Hu sees differently from economists or traders is that outside the US, these negative impacts could hit the supply side of the demand-supply equation pretty hard. A case in point is China top supplier of goods imported into the US When China recently got caught up in the COVID-19 lockdown, “the market took it as a supply depletion event,” says Hu. Meanwhile, the 10-year break-even rate continued to rise.

The takeaway is that if the dollar continues to appreciate from here, inflation could continue to run hot despite the central bank’s efforts to contain it.

Historically, the exchange rate and US inflation tend to move in opposite directions. Measures of inflation typically fall when the dollar exchange rate rises and rise when the exchange rate falls, although this relationship has been established weaker in the first half of the 1980s, when the Fed, under then-Chairman Paul Volcker, was still trying to curb inflation.

For now, traders and economists alike see a benign inflation path for the US, with inflation decelerating, although not necessarily at pre-pandemic levels. Traders of derivative-like instruments, known as fixings, expect the annual US headline inflation rate, based on the CPI report, to fall below 5% from 8.5% in March by early next year. The chart below shows how much the annual rate is expected to increase compared to prior year periods.


Source: Bloomberg

What makes Hu’s views particularly interesting is that he, too, has long been on the lower camp on inflation, believing that gains would eventually tail off. Previously, Hu was a portfolio manager for inflation at pension fund giant Pacific Investment Management Co., or Pimco, a trader at BlueCrest Capital Management, and global head of inflation trading at Credit Suisse CS.

But his views have turned 180 degrees in the past year. His recent view of the dollar’s potential impact on inflation is “not a baseline, but one that warrants a higher probability distribution. It’s one that no one positions themselves for,” he says.

“I can’t tell how big the failure of the dealers is,” Hu said. “Even the direction is counterintuitive, so if the direction turns out to be correct, most of the economic theory will have to be rewritten. I don’t even know how to assess it, but the risk is higher than what the market is asking.

“Most traders are in one of two camps: sell everything and go back to cash, or selectively buy stocks and inflation-linked bonds. I think long-term asset allocation frameworks should be biased towards investing more in inflation-sensitive assets.”

US stocks traded significantly lower on Friday afternoon amid heightened stagflation fears. Dow Industrials DJIA,
down more than 250 points while the S&P 500 SPX,
was down 0.8% and the Nasdaq Composite COMP,
fell by 1.4%. Meanwhile, 5-30 year government bond rates continued to rise above 3%. That’s why one hedge fund trader says a stronger dollar could lead to higher-than-expected US inflation

Brian Lowry

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