Making Cents of the Dollar

The US dollar’s slide is once again prompting a steady drum beat warning that the end is nigh. While a further dollar decline seems likely, its demise is likely being exaggerated and a recovery is likely late this year or early next year. This view is predicated on the understanding that what is ailing the dollar is largely cyclical in nature and, cyclically-speaking, the US is ahead of the pack and the near-term costs of the reflation policy can be expected to yield medium-term returns.

The traditional arguments of the perma-bears place great emphasis on the US fiscal and trade deficits, but these are not the main culprits now. In fact, the US trade deficit is contributing positively to growth for the first time in years. Of the 4.0% growth in Q2, the net export component accounted for almost 1.5 percentage points. The budget deficit is poised to come in well below where it had been anticipated as a result of strong corporate and household tax revenues.

More recently, the reserve diversification story has been cited as a weight on the US dollar. The most authoritative source of the allocation of reserves (the BIS and IMF) do not provide evidence of a diversification out US dollars. Indeed the most recent data suggests that central banks dollar holdings have never been greater. It is true that several countries appear to have diversified away from Treasuries, but not out of dollars.

Admittedly, some countries, including reportedly China, the holder of some $1.3 trillion of reserves, does not reveal the currency composition of their reserves. Clearly, this limits the strength of the conclusions that can be drawn, but the fact remains that there is no compelling evidence that central banks as a group have been net sellers of US dollars. Even some of the oil producing countries, which are thought to be diversifying investment funds away from the US dollar appear to have just gone on a shopping spree in the US for real assets.

The primary source of pressure on the US dollar appears to be emanating from the interest rate and growth differentials. Since the Federal Reserve completed its two-year monetary tightening cycle in the middle of last year, the market has largely been expecting a rate cut. Although US rates are still above say continental European rates, the premium offered has narrowed considerably and this has tended to erode the greenback’s value.

This is not to give the impression that the dollar’s losses have been concentrated against the euro. Year-to-date the euro has appreciated just shy of 7% against the dollar. Currencies of countries that are significant commodity producers, like Canada, Norway and Australia have appreciated considerably more than the euro (16.5%, 13% and almost 10% respectively). The rise in commodity prices appears to have a number of causes, including the insatiable appetite of the rapidly growing China, new investment capital pouring into the relatively smaller markets (compared to the financials), and the fact it is more expensive to access the metals and minerals. And this is not even to mention geopolitical issues or shortage of refinery capacity in the US.

The Federal Reserve delivered a bolder than expected 50 bp rate cut and, as one would have intuitively expected, the dollar’s slide accelerated. The fact that the dollar fell can be of no surprise to Fed officials who unanimously sanctioned the large move. The dollar’s decline has been orderly and based on fundamental considerations.

A further decline in the dollar is likely. The euro has never been higher, but ironically the dollar has been lower against the European currencies. Prior to the advent of the euro, in the spring of 1995, the dollar was about 3% lower against the German mark. Converting this record low for the dollar to the euro would put the single currency a little more than 3% higher to near $1.4570. This appears to be the next important psychological target.

However, if the dollar’s decline is largely cyclical as we argue, then we should anticipate that the end of the dollar’s multi-year downtrend comes to an end either late this year or in the first part of next year. The US has once again demonstrated its pro-growth stance by being the first to ease monetary policy among the major industrialized countries. While some commentators are playing up the risk of the US recession, the Japanese economy already contracted (1.2% in Q2) and officials there are still contemplating tighter monetary and tighter fiscal policy.

European officials still want to claim that that they are largely unaffected by the turmoil in the capital markets or the 40% increase in oil prices. Yet it seems clear that the European economies have lost some momentum. Note that the flash readings on the Sept purchasing manager surveys for the euro-zone were much weaker than expected and if confirmed in the final readings, are at or near two-year lows.

The risk is that by early next year, if not before, the market will begin anticipating an ECB rate cut. Around the same time this works its way through, the impact of what appears to be aggressive Fed easing (100 bp already off the discount rate and 50 bp off the Fed funds rate), coupled with the additional easing of conditions represented by the dollar’s trade-weighted decline, will likely see optimism return for the US economic outlook. The pro-growth stance of the US may renew the attractiveness of US asset markets and direct investment.

There is little sign that the dollar’s slide is prompting a capital strike against the US. Some observers have cited the fact that the US bond market has sold off in the aftermath of the Fed rate cut. Yet it has been a global move. Over the course of the past week, the US 10-year yield has risen by 20 bp, while the German 10-year yield has risen 19 bp and the 10-year UK gilt up 21bp. While the break-even on the US Treasury’s Inflation Protected Securities (TIPS) has shown some increase in inflation expectations, it too appears to have been largely matched by similar instruments in Europe.

In conclusion, we expect the dollar’s decline to continue for a bit longer, but suspect that we have entered the latter phases of a multi-year move. We expect that over time, investors will reward the US for its pro-growth stance and that this will lift the greenback from what is likely to be seen, even if in hindsight, as an over-shoot.