In our previous update, we highlighted our views on U.S. growth expectations, our directional view for the dollar, and reiterated our bullish macro outlook.
Since then, we have seen further resolution to the U.S. growth scare, which has driven a prevailing rally in the dollar. This significant dollar strength has been a key culprit for declining global liquidity conditions over the last two months and could pose a medium-term risk to asset markets if left unresolved.
So what have been the core drivers of the dollar’s resilience in recent months, and what are the good, bad, and ugly macro scenarios heading into 2025?
Causes of Persistent U.S. Dollar Strength
One thing to note is that despite substantial doom and gloom regarding the dollar’s dominance over the last few years, a strengthening dollar is not anything new. In fact, the dollar has been in a secular uptrend for the last 16 years.
Unpacking the drivers of the dollar rally, a few key factors have contributed to a stronger dollar in recent months:
- Resilient U.S. Economy and U.S. Exceptionalism: The U.S. economy has shown remarkable strength, outpacing growth in other major countries. This economic resilience has made the U.S. a much more attractive place for foreign investors, effectively drawing capital into U.S. markets, which has helped support the dollar’s dominance.
- Weakening Foreign Economies: In August, we called for an increase in global liquidity due to many countries being forced to loosen policy to keep their economies afloat. This dynamic is still happening, with the EU, Canada, and China guiding weaker expectations for their respective currencies (i.e., the Euro, the Yuan, and the Canadian dollar).
- Higher U.S. Rates: While many other countries have been forced to implement much more stimulative fiscal and monetary policies, the Federal Reserve has held interest rates higher and maintained its balance sheet run-off. This difference in policy has exacerbated the weakening of other currencies relative to the dollar.
- Expectations for Trump’s Policies: The election of Donald Trump has been a positive driver for dollar strength due to expectations of policy shifts such as tariffs and deregulation, which could put substantial upward pressure on both growth and inflation.
Impacts of Dollar Strength
The chart above highlights the dollar index and global liquidity. The green boxes represent periods when the dollar is falling, and the red boxes represent periods when the dollar is rising.
There are two key negative impacts that dollar strength could have on the economy and markets:
- Liquidity Contraction: What you’ll notice in the chart is that the dollar is an inverse leading indicator of global liquidity. Meaning, a strong dollar is a dampens global liquidity. This is largely due to its association with tighter financial conditions, reduced risk appetite, and contracting credit.Â
- Pressure on USD-Denominated Debt: Because such a high percentage of cross-border lending is denominated in U.S. dollars, if the dollar continues to strengthen, it could force foreign investors to sell assets to pay off USD-denominated debt.
US Liquidity Dynamics
To examine U.S. net liquidity, we use the sum of the Federal Reserve balance sheet minus the Fed’s overnight reverse repo facility minus the U.S. Treasury General Account (Balance Sheet – Reverse Repo – TGA). Looking at the chart below, you can see a clear—and rare—divergence between stocks and U.S. net liquidity happening for much of 2024.
This divergence has been the result of strong growth and corporate profits along with increasing global liquidity in the first three quarters of 2024. These factors have effectively kept asset markets strong despite the decline in domestic liquidity.
The key factor that will likely positively impact U.S. and, by extension, global liquidity conditions at the beginning of 2025 is the U.S. debt limit negotiations and TGA spend-down.
U.S. Debt Ceiling Negotiations
The U.S. will hit its debt limit on January 1, 2025, which will begin the often long and controversial debt ceiling negotiations that generally take place.
Before Congress reaches an agreement to extend the debt limit, the U.S. Treasury is not able to borrow more money, leaving the Treasury in a situation where it is forced to spend down the balance in the Treasury General Account (TGA)—you can think of this as the Treasury’s checking account.
This dynamic of the Treasury spending down the TGA, while no more bonds are being sold, is positive for net liquidity conditions.Â
The above chart plots the U.S. national debt (black line) and the Treasury General Account (blue line). Looking at the flat periods in the national debt, you can see times in the past when the debt limit was hit. What you will also notice in the red boxes is that during the three instances of debt ceiling negotiations, the Treasury General Account was spent down by a significant margin, easing liquidity conditions in the market.
The reason it often takes months to raise the debt ceiling is that you need at least 60 votes in the Senate to extend the debt limit. The party with a minority in the Senate pretty much always leverages this as a negotiating tool.
Global Liquidity
Digging into global liquidity and U.S. net liquidity, we are seeing the manifestation of the dynamic mentioned earlier regarding easing global liquidity conditions while the U.S. remains tight.
Something interesting that can be noticed in the chart below is that U.S. liquidity typically looks to be a leading indicator of global liquidity, at least in regards to longer-term cyclical trends. However, more recently, we have seen U.S. liquidity continue to trend lower while global liquidity has trended higher (shaded areas highlight declines in U.S. liquidity).
The largest contributor to rising global liquidity over the last year has been China. This is mostly due to its deflating economy, which has forced aggressive intervention from the People’s Bank of China (PBoC)—highlighted in the chart below. It is likely this increase in liquidity coming from China that has driven Bitcoin out of its six-month period of downward consolidation.
Sticky Inflation Developments
The U.S. CPI and PPI were just released for the month of November. The CPI came in at expectations of 2.7% YoY, while the PPI came in hot at 3% YoY, significantly above expectations of 2.6%. This marks the second consecutive month higher for CPI, while the PPI has already been trending higher since bottoming in June 2023.
This signals to us that there is an increasing probability that inflation will begin to trend higher into 2025, potentially posing a threat to markets. However, our belief is that the inflation threat will not likely be of high consequence unless it forces the Fed to pivot to a more hawkish policy stance.
The Macro Outlook
For now, we are maintaining a moderately bullish three-month outlook. The short-term bull case is that the Fed cuts interest rates in December and ends the balance sheet runoff in Q1 2025, while Congress has a drawn-out debt ceiling negotiation, driving the TGA spend-down. These positive scenarios for U.S. liquidity would likely put downward pressure on the dollar, which would be positive for global growth.
The main risks that could upset this outlook are as follows:
- Continued Dollar Strength: The persistent strength of the U.S. dollar remains a significant risk heading into and throughout 2025. The dollar’s strength, fueled by U.S. economic resilience, weaker foreign economies, and higher U.S. interest rates, has already dampened global financial conditions. If this trend continues, it could create sustained headwinds for the current risk-on market regime.
- Further Deterioration of Global Liquidity Conditions: Global liquidity conditions have declined following the Q3 upturn due to dollar strength. While aggressive easing measures from China have been a key driver of rising global liquidity, a prolonged decline in U.S. liquidity could weigh heavily on asset markets. The upcoming U.S. debt ceiling negotiations and TGA spend-down may provide some relief to U.S. liquidity in the medium term, but failure to recover global liquidity could heighten market fragility.
- Reaccelerating Inflation Forcing a More Hawkish Fed: Recent CPI and PPI data suggest that inflation could trend higher into 2025. While current levels do not yet pose a significant threat, persistently accelerating inflation could become a risk if it forces the Fed to pivot away from its asymmetrically dovish stance.
Quantitative Systems and Current Positioning
Join The Shift Premium Research To Unlock These Insights
Upgrade to Premium and take your crypto Portfolio to the next level with our tested and proven process that helps you know, What to buy, When to buy, and when to sell so you can effortlessly stay on the right side of the market trends and capitalize on this major opportunity! Try It Free For 7 Days.
Monthly
- Quantitative Positioning Signals
- Actionable Trade Alerts and Analysis
- Macro & Crypto Market Updates & Analysis
- Market Research and Education
- Actionable Investment Ideas
- Access to Our Community and Team
Annually
- Quantitative Positioning Signals
- Actionable Trade Alerts and Analysis
- Macro & Crypto Market Updates & Analysis
- Market Research and Education
- Actionable Investment Ideas
- Access to Our Community and Team