Things That Stick Out - The Dollar Selloff

The dollar's selloff in recent weeks can be attributed to factors both seen and unseen.

The most visible to market participants is a rapidly developing consensus that economic weakness will force the Fed to moderate its policy rate trajectory, undercutting a key element that drove the dollar higher for much of the year. We disagree with that view of the Fed, but that's what makes markets.

Less obvious are the machinations in Washington to shove through more fiscal spending in the lame-duck session before Republicans take control of the House of Representatives in January.

Congress faces a December 16 deadline to craft terms to fund the government through the current fiscal year, along with requests for more money for the military and Ukraine.

But the most controversial legislation will be over the debt ceiling, which sits just below $31.4 trillion and covers expenses only through early 2023. Democrats want to eliminate the debt ceiling altogether but don't have 60 votes in the Senate to make it happen, which is why they are likely to attempt to use the budget 'reconciliation' process to advance it on a straight party-line vote.

Politics aside, the government continues to be the Fed's worst enemy in fighting inflation by its apparent lack of willingness to control spending. FX markets understand that eliminating even the fig leaf of fiscal probity sends a bad message.

By contrast, the Treasury market has not shown the same concern, and prices remain firm.

Given the profligate fiscal backdrop, and 7.7% CPI, lending long money to the government with a 3-handle doesn't appear to us as a great risk/reward trade.

Similarly, shouldn't the stimulative effect of a weaker dollar steepen the yield curve? Until just recently, the correlation between the yield curve (flatter) and the dollar (stronger) has been tight.

As we wrote last week, for these and other reasons, the curve looks like a cheap long play here.