16 September 2020
GAM Investments’ Julian Howard discusses the recent weakening of the US dollar and why he believes the decline can be explained by near-term market forces, specifically interest rate differentials.
Lionel Shriver’s 2016 dystopian novel ‘The Mandibles’ describes the US defaulting on its debts, resulting in the collapse of the once-mighty US dollar and the ushering in of a period of deep secular decline. Comparisons with today are tempting given the pandemic crisis and social and political unrest in America. The US dollar’s recent falls particularly resonate. The near -10% correction in the Bloomberg US dollar index (DXY) from 20 March to 15 September is being touted as evidence of the imminent end of the dollar as the world’s only reserve currency – and of America’s superpower status. For non-US dollar based investors, this dramatic claim warrants careful assessment, since many popular investments like the S&P 500, the Nasdaq 100, US Treasuries and even gold are all priced in US dollars. Though non-US investors in these assets may not have noticed it yet given their strong underlying performance, the greenback’s decline since March will have had a quietly corrosive effect on net returns as dollar-denominated performance is translated back into a stronger ‘home’ currency, such as the euro or sterling. Should the dollar decline continue at the same time as momentum in these US-based assets falters, it could have profound consequences for non-US investors’ portfolios.
While it is tempting to paint a picture of a great US dollar crisis unfolding before us, the historical context is less supportive. There have only been two great reserve currencies in modern history, the first being sterling. Sterling’s loss of status was slow and tortuous, like the decline of the British Empire itself. It took two ruinous world wars for it to cede ground to the US as the primary currency of international trade. Corelli Barnett wrote of the immediate post-war period: “The dream of Britain as a global power also included the 'invisible empire' of the sterling area, to which Britain chose to play the banker. This was despite the fact that her reserves of gold and dollars were well known in Whitehall to be far too scanty for this role.” While it is true that the US budget deficit is now set to reach a startling 15% of GDP this year, suggestive of similar diminution of financial firepower, the US Treasury can borrow at less than 1% while recourse to outside help is not as vital as it was for Britain since the Federal Reserve (Fed) is aggressively buying up US debt as part of its quantitative easing programme, see Chart 1.
Chart 1: Guaranteed lender, free money: US ability to pay debt vastly different to post-war UK’s. From 31 December 2007 to 14 September 2020:
The US also enjoys an entrenched position of dollar privilege which will be hard to unwind quickly. First, a process of dollarisation observed in recent decades has seen many countries and their savers aligned to various degrees with the US dollar for the purposes of stability and lower borrowing costs. International trade receipts are now mostly denominated in US dollars, for example 60% of Turkey’s imports are priced in US dollars while only 6% of its total imports actually come from the US. This has come about partly from convenience but also as a result of a virtuous network effect. Increased invoicing in a currency tends to create demand for that currency as a safe store of value, lowering borrowing costs in that currency and increasing demand for invoicing in that currency. The US dollar’s stability has therefore ensured a dominant position which feeds back into that same sense of stability. It has been argued that a more serious threat to the dollar comes from China’s renminbi. It is true that deliberate Chinese policy has ensured its currency is now used in 25% of Chinese trade having been used in virtually none in 2010. However, full global adoption of the renminbi will still require convertibility, capital account liberalisation (ie no restrictions on taking money out of the country) as well as stability and trust in Chinese financial institutions, including its central bank. The latter point is crucial: the Fed is well respected precisely because it is independent and in recent years has fought off political interference. This is simply not the case for China’s central bank.
Instead, the US dollar’s recent and modest (by historical standards) decline is better explained by near-term market forces, specifically interest rate differentials. Given two different interest rates for two high quality investment grade bond markets, investors will tend to choose the higher interest rate. In turn, capital flowing to those bonds pushes the associated currency up. This has been the case with the US dollar versus the euro. On 15 September 2019, the 10-year US Treasury offered over 2% more yield than the 10-year German bund, and a euro bought just USD 1.10. A year later, the 10-year US Treasury only offered around 1% more yield than its German equivalent, and a euro now bought fully USD 1.19.
Chart 2: Rate differentials offer compelling explanation for US dollar ‘decline’. From 31 December 2004 to 15 September 2020:
If we accept that interest rate differentials are a major influence on a currency, then it is possible to make some intuitive assumptions on what might happen next. The Fed’s target upper bound interest rate has fallen to a barely positive 0.25% and, as the US economic situation has deteriorated, pressure has grown on the institution to do even more. In late August, Fed Chair Jerome Powell duly announced that any inflation rising above 2% will be tolerated for short periods of time. In other words, interest rates would remain low even if inflation returned. However, the Fed has stopped short of full ‘Europeanisation’, firmly ruling out negative interest rates back in May. Contrast this with the European Central Bank’s ‘whatever it takes’ response to the stagnating eurozone economy. In a speech at the end of August, ECB executive board member Isabel Schnabel stated that “the positive effects of the negative interest rate policy have exceeded their side effects.” While Chart 2 suggest a little more dollar weakness may be possible, if the ECB pursues an even deeper negative rate policy – and the rhetoric suggests they are open to it – then the differentials will surely tip back in favour of US Treasuries and the US dollar.
While it is easy to subscribe to a narrative of US epochal decline, the historical record and structural framework of the US dollar in the international trading and financial system suggest that any such decline will take more than the mere five months that the currency has been falling this year. Some of the negative commentary may be related to recent social and political unrest and the acrimonious nature of political debate ahead of the November election. It should also be noted that two of the most popular dollar ‘crosses’, the euro and sterling, face deep structural problems of their own. The eurozone, already struggling with low growth and challenging demographics, confronts a precipitous fall in global demand when its economic model relies precisely on manufactured exports to the world. The UK, for its part, faces not only a growth hit from the pandemic, but formal exit from the European Union with little sign of any trade deal and, eventually, a very real risk of the breakup of the UK itself through Scottish independence. In our view, the strongest case against further US dollar declines surely lies in the more prosaic nature of interest rate differentials. And the recent narrowing of these between the US and the euro among others looks set to be near its limits. Finally, it should be remembered that the US offers investors access to markets and sectors simply unavailable elsewhere. The mighty S&P 500 and Nasdaq 100 indices, with their innovative companies and high quality managements are not readily mirrored in other regions. Moreover, US Treasury bonds, backed by the full faith and credit of the US government, offer safety demanded by institutional investors the world over. Lionel Shriver’s vision of a declining America and busted currency might make it emotive reading for our time, but the evidence suggests it will remain fiction.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of the manager in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The companies listed were selected from the universe of companies covered by the portfolio managers to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. September 2020.