The strength of the USD

Stephen Miller

USD: the “cleanest dirty shirt”. It wasn’t that long ago that “dollar debasement” was flavour of the month.

• An adversarial stance on trade and geopolitics was thought to lead to a diminution of investment flows into the US
• Central banks were thought to wish to diversify away from USD
• The Fed at the start of 2026 was thought to be in easing mode and there were concerns regarding its independence
• The Administration revealed an antipathy to the notion of “exorbitant privilege”.

• Huge investment flows into the US equity and corporate bond markets associated with massive AI related capex have replaced negative views around trade related and geopolitical withdrawal from the USD.
• European turmoil. Europe’s status as a safe haven has diminished.
• The Fed is on a tightening tack
• Oil prices increase the attraction of the USD now that the US is a net petroleum exporter
• Gold is recovering from 2025’s speculative excess.

Ebullient equity market meets anxious bond market

The headlines in the financial press are replete with anxiety over such “high” bond yields. Ordinarily, such a surge in bond yields would presage anxiety in equity markets.

Yet the US equity market (measured by the S&P500 index) has powered to record highs as recently as Tuesday and it remains just shy of there. What gives?

• Large parts of the equity market are languishing.
• The boom is “narrow” (AI and tech related). These are not troubled by higher bond yields (yet!). A big structural shift has seen massive capex validated by muscular earnings growth.
• May yet have a way to go (although there will inevitably be setbacks).
• Investors should be wary of the challenges around higher bond yields.
• But strong outperformance in particular sectors (AI and tech) can overwhelm underperformers and drive equity markets (particularly the US) higher despite the challenges posed by higher bond yields.

The US Dollar: the “cleanest dirty shirt”

Johnny Cash had a hit with Kris Kristoffersen song Sunday Morning Comin’ Down. In that song, the protagonist laments that:

…the beer I had for breakfast wasn’t bad
So I had one more for dessert
Then I fumbled through my closet for my clothes
And found my cleanest dirty shirt…”

Maybe the “cleanest dirty shirt” is an apt analogy for the US Dollar. One of the more surprising developments this calendar year has been the strength of the USD.

It didn’t seem that long ago when “dollar debasement’ was flavour of the month. It appeared that there was some sort of consensus among the financial market punditry that the USD was poised for a period of long-term decline. (This pundit was sympathetic to that viewpoint.)In essence that reflected some uncertainty over the durability of the USD as a safe-haven destination, which in turn reflected a number of factors, including:

• An increasingly adversarial approach to trade and geopolitics that was thought to diminish the attractiveness of the US as a destination for investment flows;
• Diversification away from the USD and US government bonds as a source of foreign currency reserves by central banks and sovereign wealth funds;
• An antipathy on the part of the members of the Trump Administration to the notion of “exorbitant privilege” (which manifest itself in an overt desire for depreciation of the USD); and;
• A view that the Fed was likely to cut the policy rate and fears over the independence of the US Federal Reserve.

And alternatives to the USD are limited.

For one thing, gold prices had by early 2026 begun to behave in a manner that suggested excessive speculative flows. Perhaps the most notable twist on the negative USD scenario is that there are demonstrable offsets to the aforementioned investment flow concerns.

These offsets have largely taken the form of flows into the US equity and corporate bond markets associated with massive AI related capex.

In some measure that reflects a relatively more welcoming US regulatory environment for capital in the US than Europe (and Australia for that matter).

Strong capex is reflected in robust US productivity growth. The rest of the developed world is languishing.

It is also clear that other developments have soured the attractiveness of alternatives, particularly in Europe where the rise of extreme right and left political groupings have created an environment of political and economic uncertainty.
Those developments come on top of an overly complex regulatory regime which is not an encouraging environment for investment. (As Peter Swan pointed out in an article in the Australian Financial Review that argument might be made for Australia too).

The forgoing European difficulties have occurred against a background of continuing resilience of the US economy even in the wake of higher oil prices and higher bond yields. US economic resilience is in no small part reflective of that massive AI capex referred to earlier. This has coincided with some diminution in concerns regarding Fed independence in the wake of a September Fed policy rate increase, all of which has led to USD strength.

In saying that, I’m not suggesting that policy in the US is perfect. Far from it (think budget deficits, tariffs, erratic policy pronouncements etc.) but more that the USD is the “cleanest dirty shirt”, certainly compared to the Euro and (at least for the time being) gold.

Also of some importance is the rapid run up in oil prices in the wake of the Iran conflict. At the margin that has increased the attraction of the USD given that the US has been a net petroleum exporter since 2011. Prior to 2011 higher oil prices constituted a negative terms-of-trade shock. In the period since it is the opposite. Higher oil prices enhance growth in economic activity and increase the attraction of the USD.

But it is the allure of US as a destination for risk capital (in the form of equity and corporate bonds) that is currently the dominant theme. Same may see AI as a bubble waiting to burst, in which case the USD “dirty shirt” quickly returns to the closet.

Others see it as not a bubble but a boom. If the latter, the “dirty shirt” might get even cleaner.

Ebullient equity market meets anxious bond market

The US 10-year bond yield has surged upwards, reaching levels not seen since 2002 and is over 100 basis points higher than at the commencement of the year.

The headlines in the financial press are replete with anxiety over such “high” bond yields.

Ordinarily, such a surge in bond yields would presage anxiety in equity markets.

Yet the US equity market (measured by the S&P500 index) has powered to record highs as recently as Tuesday and it remains just shy of there.

What gives?

Well for one thing large parts of the equity market are not at record highs. The dispersion in stock performance has been historically high. The “leadership”, in terms of performance of particular stocks, is quite narrow.

Resilient economic activity reflects massive capital expenditure associated with the increasing prominence of AI in economic life.

That goes to underscore the notion that in times of big structural change, equity market performance is about more than just bond yields.

Global markets are currently wrestling with huge economic structural mega-trends that are currently more important than conventional macro or bond yield metrics in driving equity market performance.

At the forefront of these changes is the rapidity of technological advances, particularly (but not solely) in AI, and the tremendous earnings upside for companies that can best take advantage of this phenomenon.

And that is what has happened: muscular earnings growth has more than validated a huge capex spend.

Of course, while the AI earnings boom is real, ongoing investment is needed to sustain it. That in turn requires the investment to make a decent return. Higher bond yields haven’t (yet) derailed that narrative.

Indeed, seasoned equity investors like Nick Griffin from Munro Partners believe that while the occasional setback is inevitable what we are seeing in the AI and tech space is a boom not a bubble.

So yes, the macro environment is a challenging one and likely to stay that way as bond yields remain at current levels or go higher.

Oil prices now look “higher for longer” which should make investors wary. Large parts of the equity market will languish.

But strong outperformance in particular sectors (AI and tech) can overwhelm underperformers and drive equity markets (particularly the US) higher despite the challenges posed by higher bond yields.