What Will It Take to Make the Dollar Weaken?
Art by Arina Shabanova
The dollar’s long climb has plateaued lately, but the US currency is still far and away the colossus of the international currency scene. What would it take for this preeminence to languish?
Asking how and when the dollar might decline are fair questions because, despite its universal prominence globally, the buck has weakened before. “The dollar is overvalued,” said Matthew Lloyd, chief investment strategist at Advisors Asset Management. Any number of forces could knock it off its lofty perch, he said, ranging from rising inflation to a heavier federal debt load than expected.
Not too long ago, the dollar was significantly weaker. To combat the Great Recession, the Federal Reserve pushed short-term rates down to near zero and bought trillions in Treasury and mortgage bonds, to lower longer-term yields. As interest rates tumbled to record lows, the dollar ebbed substantially. From mid-2009 to mid-2011, the US dollar index dropped 17%.
Then began a rally that has lofted the buck by some 25% against major trading partners in inflation-adjusted returns. That’s because the US economy began to gather strength as others encountered difficulties.
Europe ran into its debt crisis. Japan continued a decades-long sputter. China devalued the yuan to support an ebbing economy—and earned the wrath of one Donald Trump. Most significantly, in late 2015, the Fed lifted rates for the first time in eight years and followed with eight more boosts. Upshot: Dollar-denominated fixed-income was the place that offered the best returns versus the rest of the world. “Currencies are a relative game,” noted Bob Browne, chief investment officer (CIO) of Northern Trust.
The dollar has a leg up over all other denominations in that it is the world’s reserve currency. It is used for half of all cross-border transactions, and most commodities are valued in dollars. The result is that 61% of central banks’ currency reserves are held in dollars, which they need for transactions.
There have been other times in recent memory where the greenback has been flying high, such as the early 1980s and the late 1990s, when the US economy was roaring. The US gross domestic product hasn’t been that robust in some time, with low-single-digit growth increases. Time was that low-single-digit interest would be laughable. Now, in relative terms, it’s desirable.
The American GDP is expected to rise 2.4% this year, with the European nations coming in at half that rate (Italy is worse, as it’s in a recession). “Now, 2.4% is a big deal,” said Matt Toms, CIO of fixed income at Voya Investment Management. The US is alone among developed nations in raising rates (which are likely on hold for the balance of the year), while in Europe, there actually are negative rates.
The US 10-year Treasury yields 2.5% and the equivalent German bund is at -0.09%. The comparable British gilt is just under 1%. Over the past five years, both the euro and the pound are down against the dollar by around 19%. The UK’s currency has had some rocky times due to the unending uncertainty of its departure from the European Union.
At the moment, few foresee a spectacular dollar tumble near-term. Speculators have increased their long positions in dollar futures by $30 billion last month, the highest level since December, according to the Commodity Futures Trading Commission. That said, significant dollar appreciation might be difficult, in light of the Fed’s decision to suspend raising its benchmark rate. “The Fed has put a ceiling on the dollar,” said Ed Egilinsky, managing director at Direxion.
A dollar descent has pros and cons. If the greenback did slide, the nation’s wide trade deficit likely would narrow. US exporters have a disadvantage overseas, as their products are pricier than local goods and services. That’s why President Trump is a staunch advocate for a weaker dollar, which would boost American manufacturing and employment when he runs for reelection next year.
What could bump the dollar off its throne? One of the more cataclysmic scenarios: Foreign countries dump their enormous holdings of US debt (total: $6 trillion, with $1 trillion held by the Chinese) and the dollar’s value goes screaming into the cellar. The problem with that story line is that it would be near-suicidal for these other nations, who depend on the US, as the world’s largest consumer market, to remain the prime destination to peddle their wares.
More realistic possibilities:
Higher US inflation and rates. When we think about higher inflation, climbing interest rates come to mind. At the moment, neither one seems probable. Current US inflation is very tame, 1.8% at last count. But assuming a recession doesn’t hit in the next two years, the higher inflation-interest rate duo might resurface. That happened following the 2016 slowdown. Forecasts are tepid for US earnings and economic growth in coming quarters. A resumption of the expansion tempo could change that picture.
But commodity prices are nudging up, led by energy. Whether that’s a blip or the start of a trend remains to be seen.
The thesis for the Federal Reserve’s now-sidelined rate-hiking campaign was that the country’s booming economy would eventually trigger more inflation. What if inflation kicked up, but the Fed bowed to a reelection-minded Trump and didn’t try to douse it with rigorous monetary tightening?
Investors don’t merely look at nominal interest rates. They look at real interest rates, meaning inflation adjusted. A 3.0% inflation rate overshadows a 2.5% interest rate. At that stage, interest in dollar-denominated assets might wane, and with them the dollar itself.
Mounting concerns over US indebtedness. Federal deficits and the national debt have ballooned, with the debt now at $22 trillion and escalating to the tune of $1.5 trillion per year. The worry is that, over the long-term, this will sap investor faith in the soundness of the dollar. What will happen if Washington can’t meet its obligations, short of big tax hikes or spiraling inflation?
Jeffrey Gundlach, head of DoubleLine Capital, has warned that the dollar eventually will fall because the federal red ink will scare away investors in US assets. In his most recent “Highway to Hell” webcast, Gundlach also argued that a cessation of Fed hikes in the meantime risks the wide differential that has attracted international investors to buy US assets, and would thus remove a critical prop underneath the dollar.
A calmer world. What if a lot of the turmoil holding back other currencies abated? Then the euro, the pound, the yen, the yuan, and many others could draw even or close to the US currency. For this reason, “a lot of people think a weaker dollar lies ahead,” said David Norris, head of credit, North America, for TwentyFour Asset Management.
The prospect of a deal to wind down the Sino-American trade war has sparked a surge in Chinese stocks. The Shanghai Composite is up 24% this year. Similarly, no matter how hopeless the Brexit mess seems, bourses in Britain, Germany, and France are up 8%, 9%, and 13% this year—evidently figuring that somehow things will work out.
Meanwhile, the 19-nation Thomson Reuters Core Commodity Index has rallied 10% this year after hitting an 18-month low in December. And so commodity-dependent emerging markets have seen their stocks rebound, especially in Latin America and Africa. With many commodities valued in dollars, EMs want to see the dollar drop as their goods would cost less, a spur to higher revenue.
Many people are rooting for an abased buck. And they just might get it. “We’ve hit the max,” said Frank Rybinski, chief investment strategist at Aegon Asset Management, regarding the dollar’s high level. “The dollar is swimming upstream.”
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