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Dollar danger

As the global reserve currency, the US dollar has a unique role in world trade and the debt financing of countries and companies. Therefore the value of the dollar also matters to your portfolio and asset allocation
April 6, 2017

Politics, economics and conspiracy theories blur frequently in the modern era of social media and fake news. One topic with never-ending appeal for commentators from across the media spectrum is the US dollar – a powerful symbol of American hegemony in the 20th century. From the bloggers who look for Illuminati messages in the artwork of dollar bills (the ‘evil eye’ atop the pyramid, for example), to the contrarian economists who genuinely offer an insightful alternative world view, the global reserve currency holds fascination thanks to its pivotal role in the balance of international economic and political power.

The value of the dollar relative to other currencies has a bearing on trade, returns from asset classes priced in dollars, and geo-politics. Exchange rates – the cost of buying the currency – are therefore a crucial issue for countries, companies and financial institutions that need dollars to service their debt obligations or to buy and sell raw materials. Demand for the dollar has been high over the past two-and-a-half years, and as the currency made strong gains many investors sought out dollar assets. The attraction being an additional profit from the translational effect as income generated in dollars is converted back to their own currency.

For UK investors, the slide in the value of the pound following last summer’s EU referendum has made FTSE 100 shares with high dollar earnings desirable. This will probably continue to be a smart move, with the uncertainty facing sterling over the period of Brexit negotiations, but the quality and reliability of earnings is still the most important consideration when buying shares in a company. The US dollar did experience weakness at the start of 2017, which should serve as a reminder that, with so many factors affecting exchange rates, there is scope for volatility in returns.

What was underpinning the dollar’s bull run and what could cause it to fall away?

Fundamentally, we are told, a strong dollar is a risk-on trade. Investors were bullish that US equities could maintain their positive momentum and that the pace of interest rate hikes by the Federal Reserve would be slow enough not to derail economic recovery, but still be enough to make the yield on dollar deposits attractive relative to other major currencies such as the euro or the yen.

Following the election of Donald Trump as US president, the dollar was given further impetus as traders bet on a faster pace of Fed rate increases to counter ‘Trumpflation’. The new administration was promising corporate tax cuts and higher infrastructure spending, which would also boost companies’ profits and hit the Fed’s inflation target.

The markets were, however, too quick to price in increases to earnings, which depended on passing controversial legislation through Congress. The failure to repeal Obamacare leaves a gaping hole in the president’s fiscal plans and is a wake-up call to Mr Trump that the political horse-trading in Washington is a more complex and drawn-out process than cutting deals on reality TV shows.

For the bears, the retracement of the dollar since the start of 2017 is a sign that gravity can no longer be defied in capital markets. The US funds its current account deficit by getting people to lend it money by buying dollars to purchase US Treasury bonds. It has been in the interest of creditor nations such as China to do this because America has needed someone to buy dollars to lend them the money to suck in imports. However, with the new Trump administration’s protectionist agenda, it is going to be less worthwhile for countries to lend to America.

Another argument made by bears, such as UBS’s Paul Donovan writing in the Financial Times, is that around the world countries could start selling their dollar assets to fund fiscal expansion to try to reflate their own economies. Mr Donovan posits that, when countries such as Saudi Arabia sell dollar assets to inject purchasing power into their own economies, this cash ends up being used to buy goods from other manufacturing nations such as Germany. To do this they buy euros, so USD/EUR slides. Again, according to this theory, heightened protectionism could be bad for the dollar as demand for US goods abroad is likely to be diminished.

Analysed purely in terms of purchasing power parity, the dollar also seems to be overvalued. The Economist magazine’s ‘Big Mac Index’ is a popular real world representation of exchange rates. Looking at the dollar equivalent price of the ubiquitous and homogenous Big Mac hamburger, it gives a simple demonstration of which international currencies are over- or undervalued relative to the dollar.

The 2017 iteration, which was published before the recent spell of dollar retracement, showed the dollar to be overvalued against most major currencies, with the notable exception of the Swiss Franc (CHF), as a Big Mac cost more in America when prices were converted from local currencies into dollars. One of the weaknesses of the Big Mac Index is that it doesn’t allow for the disparity in regional labour costs, so The Economist created a version that allowed for this and, unusually, in 2017 the US Big Macs were still expensive.

 

 

The reason for dollar strength lies in the euro/dollar market and demand for US Treasuries

The conventional economic theory as to why the dollar is fundamentally overvalued stacks up, but if there ever was anything conventional about the way capital markets behave, this certainly hasn’t been the case since 2008. There are plenty of reasons why, even if the dollar bull market has run out of steam, a full-on reversal is a tenuous call. A main plank of the bulls’ arguments that hasn’t fallen away is that so many countries still need dollars for their financing needs. This is because they have to meet debt obligations in dollars and the commodities they buy and sell are denominated in dollars too. The trade in dollars outside of the direct US financial system (ie anywhere else in the world) is known as the eurodollar market; it is worth trillions and its liquidity is essential to the functioning of world trade and corporate and sovereign funding. Up until a few months ago, when the dollar was still rising against most other currencies, the fear was that a lack of dollar liquidity was a major threat to the global economy.

It seems that America’s number one export is its currency and the demand for dollars has only been fuelled by the divergence in interest rate policy between the Federal Reserve and other central banks such as the European Central Bank (ECB) and the Bank of Japan (BoJ). While the Fed is still anticipating tightening interest rates, ultra-loose monetary policy continues to persist elsewhere. The effect has been for the yields on US government securities to remain attractive relative to their German and Japanese equivalents. To buy these bonds, investors need dollars.

Economic data coming out of Europe has been improving, which might suggest that the ECB could be able to turn off the quantitative easing (QE) taps and embark on its own cycle of tightening. However, the elephant in the room remains the fragility of the European banks. The ECB may be resisting the calls of the Italian government to embark on a national programme of bailouts, but arguably the central bank has already gone to enormous lengths to shore up the system. In order to provide liquidity to help banks in Spain, Portugal and even Germany repair their balance sheets, the eurozone has been thirsty for QE even as its wider economy appears to recover. In fact, this is another reason that yields on German Bunds are still in negative territory.

 

 

Profitable corporations would rather buy government paper than deposit their earnings overnight in banks, and when they do they require government bonds as collateral in repo agreements. This demand helps suppress the yield on European paper, ensuring that, regardless of what’s happening with the Trump trade in America, in terms of yield on high-quality government securities the dollar-denominated US Treasuries remain the only game in town.

Dollar carry trades

There is also a long shadow cast by dollar carry trades. A carry trade involves borrowing in one currency with a low interest rate and then converting the money into a currency with a high interest rate, then investing in securities of that second country. This is manna from heaven to large trading outfits, which can borrow with enormous leverage to magnify their profits if the securities invested in rise in price, and from the positive carry, when the yield on securities purchased outstrips that of the currency borrowed in.

The policies of central banks have encouraged the development of two carry trades in particular that both require vast quantities of dollars and introduce an element of risk to the global financial system. On the one hand the Bank of Japan introduced zero interest rates to reduce the value of the Yen and this has enabled investors to borrow for nothing and make a leveraged trade to buy dollars, with the carrot of rising interest rates. Using these dollars to buy US treasuries and stocks has also been profitable. Another trade involves borrowing dollars at still relatively low rates to buy the debt securities of emerging markets, which pay a much higher rate of interest.

The danger, however, is that these trades push up demand for dollars, which increases the exchange rate with other currencies. This makes it more difficult for emerging economies to afford payments of the yields on their debt as these payments are pegged to the value of the dollar. As of 2016, emerging market economies owed $5.7 trillion and an increase in defaults by emerging market bond issuers would result in a huge unwinding of the carry trade. Emerging market bonds would sell off in turn, creating more dollar demand as investors would have to re-pay their dollar loans and – even in the likely event of default – demand for the dollar would continue as investors rushed into safe haven dollar assets such as US Treasury bonds and gold.

Such a scenario is potentially enormously painful for emerging market economies as much of the debt issued has been from corporations. Whereas sovereign governments have some foreign exchange reserves to counter the threat of a rising dollar, companies may not be able to tap emergency lines of liquidity and could end up having to slash jobs to fund their debt, or just go bust. The Fed’s tightening of monetary policy adds to these worries, as higher interest rates encourage more dollars to stay onshore and this makes it more expensive for emerging countries to pay their debts.

The strong dollar at the end of the 1990s was one of the main reasons for the Asian financial crisis as many of the Tiger economies were stopped in their tracks by the rising cost of servicing sovereign debt. Countries such as South Korea, Malaysia, Taiwan and the Philippines will be breathing a collective sigh of relief at the dollar downtrend since the start of 2017. Even mighty China is affected as the Renminbi (RMB) is pegged to the dollar. If the dollar is strong, then China is faced with having to devalue its currency to retain the competitiveness of its exports. The dilemma being that such actions encourage capital flight, which could destabilise the domestic economy. A weaker dollar means that China can continue to export to markets around the world with a cheaper currency, yet there is no need to undermine the health of its capital account.

 

 

Geo-political machinations and moves to de-dollarisation

In the Asian economies a long-lasting and deep-rooted resentment of the Federal Reserve persists to this day. After all, their prosperity is at the mercy of a currency that they cannot print and don’t control. The allegation of ‘dollar imperialism’ is often levelled at the Fed, as rate rises that increase the cost of borrowing US dollars can precipitate capital flight, which is, it is alleged, tantamount to wealth-stripping from poorer countries as that capital finds its way back to the US.

The Russians too have suffered when the dollar is expensive. A common theory is that the 2014-15 oil price crash was engineered by the US and Saudi Arabia to hurt Russia. Another strand to this, as advanced by Bert Dohmen of Dohmen Capital, writing in Forbes, is that the US began tapering in October 2014 to strengthen the dollar and make it more expensive for Russia to support the rouble just as its oil revenues were falling. The Russians were forced to heavily cannibalise their foreign exchange reserves which, added to the fact that sanctions were putting the screw on their economy, was designed to make Vladimir Putin rethink his foray into Ukraine.

The dollar’s status allows America to wield such economic power and this has encouraged Russia and China to try to look at alternatives as a global reserve currency. There have been proposals for an alternative basket of currencies and gold, although there are obstacles. The European Central Bank (ECB) struggles with decisions to cope with the disparate economies of the eurozone and a brittle banking system, and the Bank of Japan is engaged in an enormous experiment in monetary policy.

Gold is fundamentally illiquid. For all its failings, the Fed is considerably more transparent than the Central Bank of Russia or the People’s Bank of China, and bitcoin has virtually zero governance whatsoever. The fact remains that the eurodollar market has become so huge and is so vital because of the demand to use America’s currency. So, although the Fed’s policies may be giving some countries cause to consider the magnitude of their (still inevitable) exposure to the dollar, it may be some time before dollar hegemony is truly threatened.

This means that the world still has to watch every Federal Reserve funding rate announcement with bated breath. Central bankers have become addicted to trying to control markets, yet their actions affect all asset classes including the most unpredictable and globally significant. One of the more entertaining alternative financial blogs is ‘Of Two Minds’ by Charles Hugh Smith. The author uses the analogy that the stock market has been a monkey on the central bankers’ leash, the bond market has been a gorilla – harder, yet still just about manageable – but foreign exchange is King Kong, a beast that is impossible for policymakers to control. The problem is that the Fed’s decisions, which have been aimed at providing liquidity to US institutions and boosting growth in the American economy, have not only had a major impact on equities and bonds, they may have let Kong off the leash in the forex market.