When the economy and financial markets initially stabilize next year, the market's trading focus may shift from recession to recovery, and the U.S. dollar index will also start a trend downward cycle.

Red Weekly Special | Ni Wentao

The turning point of the U.S. dollar index is often accompanied by the expansion of the global financial cycle. Looking back at history, the high points of the U.S. dollar index often appear after the high point of the Federal Reserve benchmark interest rate. When the economy and financial markets initially stabilize next year, the market's trading focus may shift from recession to recovery, and the U.S. dollar index will also start a trend downward cycle.

The US dollar index's callback in the fourth quarter of 2022 originated from the expected shift in the Federal Reserve's monetary policy after U.S. inflation fell more than expected. Against the backdrop of growing concerns about economic recession and financial stability, it is not ruled out that rising risk aversion will once again push up the U.S. dollar index for a phased rebound in the future. In the medium to long term, as the Federal Reserve completes its interest rate hike cycle, the global economy will begin to show initial signs of bottoming out, and panic in the financial market will begin to gradually subside. The timing of the dollar index's strength transition may occur shortly after the end of the Federal Reserve interest rate cycle. The U.S. dollar index has started a trend downward cycle, and as China continues to implement its stabilizing growth policy next year, China's government bond interest rates are expected to start an upward cycle.

10-year U.S. bond yield

will maintain an overall downward trend in 2023

China's liquidity environment is generally very loose in 2022 and the funding interest rate is stable and lower than the policy interest rate. Three RRR cuts in December 2021, April and December 2022 and the establishment of multiple re-lending tools have provided support for market liquidity. At the same time, three cuts in LPR, two cuts in open market operations (OMO) and medium-term lending facility (MLF) policy rates, and cuts in deposit rates have stabilized the central funding interest rate at a reduced level. Therefore, before November 2022, China's 10-year government bond yield fluctuated downward in the range of 2.60%-2.90%.

Entering the end of the year, the negative feedback from market financial management redemptions intensified, and investors gradually switched their attention from trading economic fundamentals to trading policy expectations. With the continuous optimization of epidemic prevention and control policies and the continuous implementation of supporting policies for the real estate industry, investors have strong expectations for next year's economic fundamentals. Added to this is the lagging effect of the central bank's capital return, the negative feedback of net-valued products has deepened, and the market's risk appetite has increased. China's 10-year government bond yield has risen from 2.75% to about 2.90%. Interest rates have increased from short to long, and there has been an obvious flattening upward trend.

Overseas, inflation in Europe and the United States has eased, the pace of interest rate hikes by the Federal Reserve may slow down, and the U.S. dollar index has peaked and fallen, breaking below the 105 yuan mark. Since October 2022, the 10-year U.S. Treasury yield and the 3-month U.S. Treasury yield have continued to be inverted. Looking back at history, the U.S. economic recession is basically inevitable, but the debt risk of the residential sector is very low. At the same time, the stability of the financial system has significantly improved, and the degree of this recession will most likely be mild. The 10-year U.S. bond yield will maintain a downward trend overall in 2023. The pace of decline may be fastest in the second and third quarters of next year. The downward pace will slow down in the fourth quarter and may rebound.

The U.S. dollar index and the trend of Chinese government bonds

show a strong negative correlation

Historically, the high point of each round of the U.S. dollar index corresponds to the low point of the 10-year Chinese government bond yield. The negative correlation between the two is obvious, showing the characteristics of a strong U.S. dollar index and a strong Chinese government bond and a weak U.S. dollar index and a weak Chinese government bond. The main reasons are reflected in trade, inflation and economic aspects.

The U.S. Dollar Index is an indicator that comprehensively reflects the exchange rate situation of the U.S. dollar in the international foreign exchange market. It is used to measure the degree of changes in the exchange rate of the U.S. dollar against a basket of currencies. At the same time, the strength of the U.S. dollar index also represents the economic development of the United States relative to other countries around the world.

Specifically, the calculation principle of the US dollar index is based on the exchange rates of Europe and the United States, the United States pound, the United States and Japan, the United States and Canada, the United States and Switzerland, and the US dollar against Swedish krona , and the US dollar is calculated in a weighted manner. Overall strength, with 100 as the demarcation line, of which the euro accounts for 57.6%, the Japanese yen accounts for 13.6%, the British pound accounts for 11.9%, the Canadian dollar accounts for 9.1%, the Swedish krona accounts for 4.2%, and Swiss franc accounts for 3.6%. Although the U.S. dollar- RMB exchange rate is not within the calculation range of the U.S. dollar index, changes in RMB assets will not directly affect the trend of the U.S. dollar index. However, there is a strong negative correlation between the U.S. dollar index and Chinese government bonds.

The U.S. dollar index rises and trade demand decreases.

Eventually, China's government bond interest rates decline.

In terms of trade, first of all, international trade mainly uses the U.S. dollar as the currency for pricing and settlement. When the U.S. dollar strengthens, trade demand countries will bear greater expenditure costs, so the U.S. dollar index rises and trade demand decreases.

Exports are an important part of China's economic growth. The strengthening of the US dollar index will lead to a decline in China's export trade. After China joined the World Trade Organization in 2002, the U.S. dollar weakened in a long-term cycle, and China's export trade continued to be strong. At the same time, during the middle and late stages of the financial crisis from 2008 to 2009, the global economy was in a downturn, the U.S. dollar strengthened again, and China's exports turned negative again year-on-year. From 2015 to the end of 2019, the U.S. dollar index generally remained strong. In a rising cycle, China's exports continued to be sluggish year-on-year and the growth rate slowed down.

The fluctuation of the US dollar index has an impact on international trade. Exports are one of the troika of China's economic growth. The strength of exports will further affect China's economic aggregate, and will eventually be transmitted to China's government bond interest rates. A strong U.S. dollar will suppress domestic trade and exports, causing the yuan to depreciate, while interest rates as currency prices will fall simultaneously, ultimately driving China's government bond interest rates lower.

The strong US dollar suppresses commodity prices

Low inflation drives China’s government bond interest rates lower

In terms of inflation, the US dollar serves as the currency for pricing and settlement of international commodity trade. With commodity supply and demand unchanged, when the U.S. dollar strengthens, commodity prices denominated and settled in U.S. dollars will fall.

Historically, commodity prices excluding agricultural products and crude oil have shown a clear negative correlation with the US dollar index.

When the U.S. dollar index strengthens, the cost performance of U.S. dollar assets increases and global commodity prices fall. Because global commodity prices are one of the main indicators that constitute China's industrial producer price index (PPI), because China is an economy dominated by manufacturing. The fall in global commodity prices has driven down China's inflation, and China's relatively low inflation environment will provide support for China to maintain a relatively loose monetary policy. Loose monetary policy will push China's government bond interest rates downward. A strong U.S. dollar will suppress commodity prices, causing China's inflation to remain relatively low, while the low-inflation environment will drive China's government bond interest rates lower.

The rising panic index corresponds to the strengthening of the U.S. dollar index.

The People’s Bank of China has initiated loose monetary policy to stabilize the economy.

In terms of economy, the United States is the world’s largest economy. The U.S. dollar index not only represents the trend of the U.S. economy, but also represents changes in global economic trends. As a global pricing currency, the U.S. dollar is freely convertible and has a hedging effect. When the fundamentals of the global economy are impacted and resonate, the US dollar's hedging effect appears. Affected by supply and demand factors, the demand for the US dollar rises, pushing the US dollar index higher.

Historically, the panic index and the U.S. dollar index continue to maintain a strong positive correlation, and a higher fear index corresponds to a stronger U.S. dollar index. Globalization has led to global economic resonance. Whenever a global crisis occurs, China often uses loose monetary policy to stabilize economic fundamentals. When the global economy encounters a crisis, panic spreads and risk aversion increases, driving the U.S. dollar index to strengthen.At the same time, the People's Bank of China launched a loose monetary policy to stabilize the economy. The decline in China's capital interest rate drove the decline in China's government bond interest rates. China's government bond interest rates and the US dollar index showed an opposite trend.

The U.S. dollar index strength conversion point

occurred shortly after the end of the U.S. interest rate hike cycle

In the future, the U.S. dollar index turning point will often be accompanied by the expansion of the global financial cycle. Looking back at history, the highs of the U.S. Dollar Index tend to occur after the highs of the Federal Reserve's benchmark interest rate. On the one hand, it needs the Fed's loose monetary environment; on the other hand, it needs initial signs of stabilization in the global economy.

Looking forward to 2023, higher interest rates will drive demand contraction in the United States, which will end the Fed's monetary tightening cycle on the one hand; on the other hand, it will increase risks to financial stability.

In short, the trading theme of the market in 2023 is between economic recession and financial stability. The US dollar will benefit from the risk aversion logic, and the US dollar index will see repeated trends. With the end of the Fed's tightening cycle, the European and American economies may gradually begin to show some preliminary signs of recovery, and concerns about financial stability will also begin to gradually ease. When the economy and financial markets initially stabilize, the market's trading focus may shift from recession to recovery, the U.S. dollar index will also start a trend downward cycle, and Chinese government bond interest rates are expected to start an upward cycle.

(This article was published in "Red Weekly" on December 24. The opinions expressed in the article only represent the author's personal opinion and do not represent the position of "Red Weekly". The mention of individual stocks is only for example analysis and does not make trading recommendations.)