Investors are searching for answers to when inflation will abate amid fears of an impending recession. As prognosticators parse data and projections, Morgan Stanley
MS
Chief Investment Officer Lisa Shalett sees a hidden threat that could exacerbate the inflationary picture: a mostly unnoticed anomaly in the relationship between the dollar and commodity prices.

For much of the last half-century, the strength of the U.S. dollar was inversely related to the average price of commodities. When the dollar went up, and got stronger, commodities prices like oil and precious metals went down and vice versa, a product of the sacrosanct designation of the U.S. dollar as the reserve currency of the world that leads to most commodity purchases being done with the American currency.

The black swan events of Covid-19, and its resulting supply chain shocks, and the Russian invasion of Ukraine have apparently thrown this balance out of whack and may portend bad news for inflation. When these two metrics once again become tethered, the result could be a falling dollar, otherwise known as persistent inflation, despite a drop in commodity prices such as oil.

“We may get to a point sometime over the next three to six months, where the dollar starts to weaken on a relative basis as the US economy slows, and as other economies and central banks start to tighten,” Shalett says. “It may be that we get into a scenario where even though the Fed may have some success squashing demand [for goods and services], we may not squash inflation.”

This decoupling of the dollar and commodities has only happened twice since 1966. In 1979, inflation surpassed 14% and gold prices soared to more than $850 an ounce from less than $50 a few years prior. In the 1980s Fed Chairman Paul Volcker, who was appointed by President Carter, raised interest rates, ruthlessly moving the Federal Funds rate has high as 20%, ushering in a recession that collapsed inflation as well as commodity prices while the dollar strengthened. In 2001, commodity prices took off but with China being admitted to the World Trade Organization and flooding the U.S. market with low-cost goods, inflation was kept in check.

The current situation is a result of a preceding decade in which U.S. assets have massively outperformed global assets, creating a demand for dollars as well as a defensive posture in many economies over the past few years causing other countries to overbuy U.S. dollars.

If the weakening of the U.S. dollar occurs, it could mean a windfall for emerging markets that have had weaker currencies, especially those that are commodity producers. This impact is already showing up with emerging markets outperforming U.S. equities in the month of June with the Vanguard FTSE Emerging Markets ETF down 2% this month while the S&P 500 is down 4.9% in the same time period. Emerging markets haven’t outperformed U.S. equities since 2009, according to Shalett.

As Shalett watches to see whether a commodity price drop or U.S. dollar value drop brings these two data points into equilibrium, she has her eye on the world’s third-largest economy, Japan.

The Japanese are facing their own currency crisis with a weak Yen threatening to send the country into a recession. As one of the largest buyers of U.S. treasuries, if the country opts to reduce those purchases in reaction to a worsening economic picture it could tip the balance toward the dollar weakening while commodities stay expensive.

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