By Philip Lawlor, head of Global Investment Research

Following a long rally, the US dollar slid 5% against a basket of other major currencies in July, marking its worst monthly decline in more than a decade. The causes and ripple effects of this drop have important implications for future market performance.

As the chart below illustrates, the dollar’s July pullback has almost solely been about the strength of other developed-market currencies, particularly those of northern Europe, the euro and the pound sterling.

FX moves vs. US dollar – Month ended July 31, 2020

Source: FTSE Russell / Refinitiv. Data as of July 31, 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.

The culprit – negative US real yields

The US dollar’s weakness can be linked to the dramatic drop in US real (i.e., inflation-adjusted) yields. As shown below, yields on the FTSE US 3-5yr inflation-linked bonds have collapsed since May and are now deeply into negative territory. This has reduced the relative attractiveness of owning US dollars for investors.

Trade-weighted US dollar index vs. real US Treasury yields (rebased)

Source: FTSE Russell / Refinitiv. Data as of July 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

The longer-run view

When put into a longer-term perspective, however, last month’s downdraft doesn’t look so remarkable. Although the greenback has slipped below its 200-day moving average recently, the July pullback pales in comparison to the quantum declines of the mid-1980s and early 2000s. In trade-weighted terms, the US currency is still above its 10-year average.

Trade-weighted dollar index vs. 200-day moving average

Source: FTSE Russell / Refinitiv. Data as of July 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

The falling USD has helped emerging markets…

One of the consequences of the recent dollar depreciation of the past few months has been the outperformance of emerging markets over their developed peers since May. Emerging currencies rebounded in the early stages of the post-lockdown pickup in risk appetite, though the rally has lost momentum more recently. The weaker US dollar has also relieved pressures on the developing nations that have taken on too much dollar-denominated debt.

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FTSE Developed/FTSE Emerging Indexes (TR, local currency, rebased) vs trade-weighted US dollar index

Source: FTSE Russell / Refinitiv. Data as of July 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

…but not Russell 2000 relative performance

The chart below shows the strong positive correlation between swings in the US dollar and the relative performance of US large-caps (Russell 1000) versus small-caps (Russell 2000) over the past year. However, this linkage appears to have broken down in July. Despite the fall in the dollar, typically a signal of waning risk aversion, the Russell 1000 has held its ground against the Russell 2000. This trend reversal likely reflects the increasingly uncertain US recovery backdrop, thus favoring the less domestically exposed large-cap index over its small-cap counterpart.

Russell 1000 relative to Russell 2000 (total return, rebased) vs. USD real effective exchange rate (REER)

Source: FTSE Russell / Refinitiv. Data as of July 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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