So far this year, the dollar has risen 12.9% versus the euro, while the MSCI world index has recorded a gain of 10.2% in euro terms (see chart below). Considering the Fed is set to hike rates in December (the fallen bond king Bill Gross even said recently he is 100% sure of such a move), the dollar play looks far from over yet.
Tim Peeters, head of securities portfolios at multi-family office Portolani in Belgium, is a long-standing dollar fan. He has maintained an allocation of some 20% to dollar cash or near-cash (short-duration bonds) throughout the year. After the euro unexpectedly strengthened versus the greenback in August, Peeters increased his allocation to dollar cash to 25%.
“Personally, I would now tactically convert this excess position back to euros, as I think a December rate hike has been largely priced in,” says Peeters. But on the longer term Peeters believes he will stick to his dollar bet. “Admittedly the best profits [from a dollar allocation] have already been made, but I don’t really see any benefits in converting my dollars back to euros. The dollar offers diversification benefits and is a safe haven as the world’s reserve currency.”
Dollar and equities in tandem
Even more striking than the outperformance of the dollar bet versus the MSCI World, is the latter’s unprecedentedly strong correlation with the dollar/euro exchange rate. Whenever, the dollar strengthened this year, so did the MSCI World Index. And the S&P 500 index actually, which interestingly has generated exactly the same return year-to-date to euro-based investors as dollar cash.
"Hedge funds take cheap loans in euros to invest them in dollar assets. When market sentiment sours, they sell these assets again and convert the funds back to euros" - Tim Peeters
So what is driving this correlation? According to Peeters, there is a rather straightforward explanation for the euro performing relatively well when market sentiment is negative. “This is caused by hedge funds who are attracted by the low borrowing costs in Europe,” he explains. “They take cheap loans in euros to invest them in dollar assets. When market sentiment sours, they sell these assets again and convert the funds back to euros. That causes the euro to appreciate.”
Following this logic, the recent dollar rally, partly induced by sound economic data from the US and hints from the Fed that a December rate rise is likely, is in a large part attributable to the strong equity market performance in October.