As Energy Shock Morphs Into Growth Slowdown, Goldman Asks Whither The Dollar

The recent oil price shock has driven the Dollar and yields higher primarily through a large increase in inflation pricing globally, with the Dollar benefiting most from its safe-haven status and the US's net oil exporter position...

While markets have been more focused on the inflation consequences of the energy price shock rather than the growth downside, Goldman Sachs' Isabella Rosenberg warns that risks skewed towards that changing over the near term if the conflict and associated disruption extends. 

The Dollar has strengthened across G10, with more rates-sensitive FX underperforming...

Inflation has been responsible for the majority of the increase in front-end yields...

Markets may continue to price inflation risks and relative terms of trade for some time, but the bigger question is how the mix of FX price action will shift if the market begins to focus more on growth downside.

We think it would likely mean more muted Dollar appreciation versus G10 broadly as safe havens like JPY and CHF start to outperform and deeper underperformance across EM.

The oil price shock has tightened our GS US FCI by about 50 basis points so far.

At first, the tightening was concentrated in rates, with higher long-end yields contributing the majority of the increase in the US FCI vs equities.

More recently, equities have begun to drive a relatively larger share of the tightening in the US FCI, about 25 basis points so far.

This relative change can indicate that the impulse to financial conditions is shifting away from inflation risks and towards growth risks.

Using our cross-asset strategists’ model for growth and policy shocks also suggests that the tightening has been predominately policy-led rather than growth-led; in other words, inflation risks have made a greater contribution to the US FCI tightening than growth concerns.

Models suggest hawkish policy risks have made the greatest contribution to recent FCI tightening

The Dollar typically strengthens during a tightening in financial conditions due to its safe haven status.

But the composition of Dollar strength varies depending on whether rates or equities are driving the tightening in financial conditions.

If the mix of FCI tightening is rates-led - i.e. rates are contributing the majority of the FCI tightening - the Dollar tends to strengthen across G10 and EM pairs.

In this environment, close USD proxies like CAD are more resilient, and more rate-sensitive currencies like JPY weaken the most.

However, if the tightening mix begins to be driven more by equities (i.e., growth concerns take over), the Dollar should continue to strengthen, but we would start to see clearer outperformance in the other safe havens, JPY and CHF.

Equity-led FCI tightening tends to be relatively worse for EM than for G10

Structurally, a more prolonged conflict could alter the global growth backdrop more significantly, meaning that an unwind of inflation risks could be more uneven across regions and reinforce downside growth and FX risks in Asia and Europe.

Ultimately, if inflation risks give way to pronounced growth risks, we anticipate continued USD outperformance against cyclical G10, enhanced safe-haven performance from CHF and JPY versus USD, and a significantly worsening outlook for EM. 

Professional subscribers can read the full "Global Markets Daily: What A Shift to Growth Risks Would Mean for The Dollar" note here at our new Marketdesk.ai portal