The Dollar: The greenback quandary
• The dollar continues to fall despite interest rate rises
• Economic and political factors, such as increasing tariffs, make the currency less attractive
• Emerging markets, commodities and asset allocation decisions all face uncertainty connected with the value of the dollar
The US economy is growing, as are inflation expectations. The Federal Reserve’s response has been to embark on the most aggressive rate-tightening cycle in the developed world, with three further hikes expected this year (see charts).
This should be positive for the dollar. Yet the greenback fell 10% in 2017. If nothing else, one would expect the dollar to benefit from some mean reversion, but still it weakens, and the consensus is that it will continue.
“Our base case is for continuing dollar weakness in the face of asset market volatility,” says Richard Benson, head of portfolio investments at Millennium Global.
Maarten-Jan Bakkum, senior strategist, multi-asset, at NN Investment Partners, agrees, saying the asset manager expects the dollar to weaken further, “driven by further fiscal pressures and the overall deterioration of the policy mix”.
Economic and political factors, such as increasing tariffs and policy unpredictability, all make the currency less attractive. “There are also momentum effects,” adds Bakkum. “If a currency has been through a period of weakening, this will likely continue.”
Another factor could be US real interest rates. It is not all about nominal rates, but their relation to inflation. It is possible that the Fed will let inflation run ahead of nominal interest rate increases, producing lower real interest rates. This is speculation, but given the emphasis on growth, it would have a negative effect on the dollar.
The timing of President Donald Trump’s pro-growth policies – January 2018’s $1.5trn (€1.2trn) tax reforms which cut the corporate rate from 35% to 21% and reduced taxes for most, along with the $1trn investment boost – is also problematic for the currency.
Benson says these moves make US political risk more acute, with many actions “seen to be rather odd. For instance, one would not normally expand the deficit when growth is strong. And one certainly would not do it late in the cycle, which means there will be no support when things roll over.” These fears around the deficit cycle have weighed down the dollar, he contends.
Jim Smigiel, CIO of absolute return strategies at SEI, agrees that it’s “an unusual time in the cycle to be embarking on fiscal stimulus”.
The stimulus package means that $1trn of extra borrowing will be needed over the next decade just to fund tax cuts. This sort of intervention was last seen in the 1980s under President Ronald Reagan, when the US current account deficit ballooned. Smigiel points out that any increased Treasury issuance will come as the Federal Reserve reduces its debt-buying programme – a factor which is “under the radar at the moment”.
The dollar’s woes predate Trump’s March 2018 announcement of widespread tariffs. Benson sees these tariffs as “heralding a trade war that Trump seems hell bent on weighing in to”. Nevertheless, “if you want a trade war, you would be better served by sitting on a weak currency”.
However, things are never that simple. “If things do turn downwards, this could strengthen the dollar, as it would play to its safe-haven status,” says Benson. Smigiel agrees that a trade war may prove beneficial for the US, and investors. “Dollar exposure, as a safe-haven currency, benefits portfolios in times of stress.”
Bakkum, however, is ambivalent about the impact of a trade war on the dollar: “Tariffs could be either positive or negative, as it’s possible their imposition may be positive for the US balance of trade.”
Another factor, according to Smigiel, is that structurally we are about a year into a weak dollar cycle. Such cycles tend to last five to seven years, he reckons: “This, however, can move in fits and starts. On the dollar-strength side, interest-rate differentials are quite high, with little sign of this changing.”
Taper Tantrum Two?
US rates are not just a matter for the US economy and holders of its assets; they have historically been a decisive factor for emerging market debt, much of which is dollar-denominated. Indeed, emerging markets can be sensitive to US policy action, as was seen in 2013 when the Fed announced a reduction in quantitative easing and bond yields surged. This period was known as the Taper Tantrum. Should holders of emerging market debt be concerned at the increase in servicing costs of the dollar-denominated portion?
While the ratio of EM debt to GDP is stable, external deficits have been reduced in the past five years.
“Compared to 2013, only Turkey has a wider current account deficit now,” says Benson, adding: “We are not especially worried about EM dollar exposure. Broadly, emerging markets have been de-risking over 2016-17. When US rates rise, emerging markets will suffer indigestion in the eye of the market, but this will subside and the underlying EM strengths will come through.”
“One wouldn’t normally expand the deficit when growth is strong. And one certainly wouldn’t do it late in the cycle, which means there will be no support when things roll over”
Bakkum also says emerging market debt will ride out rising rates and a weakening dollar. However, he prefers local-currency bonds rather than dollar-denominated ones. “Not only are the former more likely to be insulated from rising rates but, if you believe the dollar will experience further weakness, you get the FX benefit as well.”
Smigiel says that SEI prefers local currency-denominated debt: “Our base EMD exposure is 50/50, and we are running substantially higher in local currency.”
Most commodities, including oil, are denominated in dollars, and there has been much debate about the real impact of this linkage. As the dollar falls, the dollar price of commodities rises. Oil prices have been rising since summer 2017 and are now at 2014 levels, over which period the dollar has indeed fallen.
“While oil and other dollar-denominated currencies will be affected by moves in the dollar, prices are much more about supply and demand,” says Bakkum. “While China isn’t as important a driver in commodity prices as it was, credit growth in other emerging markets should lead to fixed investment, which will be supportive of commodity prices.”
Asset allocation implications
As a result of the complexities of FX markets, few are prepared to make an asset allocation based on the value of the dollar. “Currencies can be difficult to predict, and even more difficult to explain,” says Bakkum. “While the dollar is very important, such unpredictability means that we don’t take asset allocation decisions on the dollar alone.”
That said, NN remains underweight in both US equities and bonds: “US bonds in particular look vulnerable to rising yields relative to their European counterparts,” says Bakkum.
In this environment, SEI favours non-US equity markets, but Smigiel says it is “a decision that is best made separately and distinctly from currency views”.
He does note that the cost of hedging is not currently economical for developed market investors. Japanese investors, especially, will find it more fruitful to buy Bunds and hedge back into yen rather than Treasuries, he says. “All of our dollar exposure is to unhedged equity at this time. We are not massive bond bears, but we expect US rates to trend higher.”
Where the dollar heads next depends on many factors. This is in an era where predictions based on rate differentials look to be overwhelmed by other economic and political factors.