Commodities | Fiscal Policy | Monetary Policy & Inflation | US
This year’s dollar decline has resumed. Having paused during election season, the downtrend restarted as the country entered the final stage of vote tallying and certification (Chart 1). This makes sense for several reasons: 1) the likely future path of US fiscal policy; 2) Fed resistance to higher real interest rates; and 3) the dollar’s weak fundamentals, which the Covid slump has highlighted. As I have written in my series of articles prior, I believe the dollar has begun a large decline of 10% or more in broad, trade-weighted terms. Further, over longer time horizons, a much larger decline is not only possible, but likely.
While the presidency may switch parties and adopt a new rhetoric and tone, it will do so with a razor-thin margin implying no strong policy mandate. In Congress, the House appears more evenly split than before, and the Republicans appear to have retained control of the Senate. This is a recipe for the sort of fiscal policy gridlock that has generally characterised the US federal government for decades. Meaningful entitlement or defence-spending reform are almost certainly off the table. As for taxes, Joe Biden (or eventually Kamala Harris) might push in this direction as president, only to meet fierce resistance in both houses of Congress, especially the Senate. As such, the US will continue to run chronic fiscal deficits.
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This year’s dollar decline has resumed. Having paused during election season, the downtrend restarted as the country entered the final stage of vote tallying and certification (Chart 1). This makes sense for several reasons: 1) the likely future path of US fiscal policy; 2) Fed resistance to higher real interest rates; and 3) the dollar’s weak fundamentals, which the Covid slump has highlighted. As I have written in my series of articles prior, I believe the dollar has begun a large decline of 10% or more in broad, trade-weighted terms. Further, over longer time horizons, a much larger decline is not only possible, but likely.
While the presidency may switch parties and adopt a new rhetoric and tone, it will do so with a razor-thin margin implying no strong policy mandate. In Congress, the House appears more evenly split than before, and the Republicans appear to have retained control of the Senate. This is a recipe for the sort of fiscal policy gridlock that has generally characterised the US federal government for decades. Meaningful entitlement or defence-spending reform are almost certainly off the table. As for taxes, Joe Biden (or eventually Kamala Harris) might push in this direction as president, only to meet fierce resistance in both houses of Congress, especially the Senate. As such, the US will continue to run chronic fiscal deficits.
A failure to enact entitlement or defence reform or to increase taxes also implies that the US will continue to run chronic trade deficits. Entitlements and defence spending promote consumption, not productive savings or investment. Indeed, the US savings rate has been structurally low for years, notwithstanding low rates of unemployment during the past few. Whether employed or no, Americans save little, and the US requires roughly $2bn/day of foreign savings in order to cover the current account gap.
The Covid scare did trigger a brief spike in the savings rate. But even so, as public spending took up much of the slack, the current account deficit actually increased (Chart 2). That is highly unusual for the US and suggests that the external deficit may be even ‘stickier’ today than in the past. If so, this implies that the size of the dollar decline required to reduce the imbalance is commensurately greater, and that the dollar would need to remain weak for a prolonged period to encourage a sustainable shift from consumption- to savings+investment-driven growth.
Were interest rates to rise materially, that would probably change. The Fed, however, has given clear indications that it will not give any serious consideration to doing so until official inflation figures rise above their 2% reference value.
On both the fiscal and monetary policy fronts, therefore, we should expect little if any change, possibly for years. The large US external imbalance with the rest of the world will continue to grow. And so the only way for markets to compensate is to send the dollar lower and for longer.
Were the US an emerging market country, financial market ‘vigilantes’ would already have taken action to impose policy discipline. But as this is the US, the issuer of the global reserve dollar, there is huge structural global demand for US assets. Indeed, one explanation for why US equities are generally more expensive than foreign ones in valuation terms is external demand. The Swiss National Bank, for example, is a huge owner of US shares.
But what of the course on which the US remains? The UK ran chronic trade deficits during the latter half of the Victorian era. Sure, times were good. The East End docks brought in goods from all over the world. The West End was the world’s cultural capital. For the entire period, the UK and her major trading partners were on the classical gold standard. But the UK’s finances were in no position to survive the war that would break out in 1914, much less that which did in 1939. Inflation was used as a financing tool for both conflicts, and, in 1931 and again following WWII, sterling was sharply devalued.
To be clear, I’m not predicting war. But with US deficits and accumulated debts already at wartime levels, war is hardly a necessary condition to catalyse a qualitative shift in global dollar demand as a store of value (notwithstanding its leading position as a means of exchange). Liquidity is one thing, value quite another.
Even the ‘Modern Monetary Theory’ (MMT) crowd, which largely dismisses deficit financing concerns, admits that it becomes impossible for a country to run chronic trade deficits if the rest of the world is unwilling to hold an ever-growing share of that country’s assets. A chronically weakening currency is the interim result. But, beyond a certain, unknown point, even that equilibrium becomes threatened as perceptions shift regarding the currency’s long-term trajectory. If that seems like an unstable equilibrium, that’s because it is.
Implications for US Interest Rates
If we assume that the US avoids the MMT path of financing deficits directly via US Treasury currency issuance, then the Federal Reserve will continue to set US interest rates. If the dollar remains on a downward path, other factors equal, that will contribute to pushing up US inflation expectations and consequently bond yields. Eventually, if inflation expectations rise enough, implying that the CPI will exceed the Fed’s 2% reference value by at least a small amount, then based on recent statements the Fed is likely to shift rhetoric and prepare the markets for higher rates.
However, the Fed has also indicated that, as they want to see inflation exceed 2% for some period of time, they are likely to remain deliberately ‘behind the curve’. The risks of a larger-than-anticipated overshooting are therefore higher than in the past. Moreover, the Fed is well aware that the US private-sector balance sheet is considerably more leveraged than it has been in prior rate hiking cycles. As recently as Q4 2019, the brief ‘repo crisis’ was met with swift action. Real rates declined, and the dollar weakened.
As such, the road map ahead is one of structural dollar weakness and rising breakevens, with occasional but small increases, then possible reverses, in real interest rates. Eventually, the dollar will weaken enough to break this dynamic, but that is probably several years down the road. The key signpost will be a closing of the US current account gap, something probably requiring at least a moderate recession along the way.
Consequently, a period of ‘stagflation’ almost certainly lies ahead. It might be milder than the 1970s/early 1980s, but, with the US economy more highly leveraged today than then, it could feel just as painful. Stock market multiples, in any case, would compress in such an environment even if nominal earnings growth remained positive. Relatively unleveraged real assets would outperform.
That brings me to gold. News of an apparently successful Covid vaccine trial this week sent the metal sharply lower. Oil, on the other hand, bounced strongly (Chart 3). As I explained in an article earlier this year, the gold price is largely a function of long-dated oil prices, so this unusual disconnect is likely to be temporary. In any case, a stagflationary environment is highly supportive for gold.
To close, a brief word on bitcoin, which has outperformed strongly of late (Chart 4). I am a known bitcoin sceptic for a variety of reasons, but I note that a tremendous amount of speculative interest has focused on bitcoin this year. Given it is a thinly-traded market with miners – insiders as it were – driving much of the volume, anything is possible in the short term. In the long term, however, the only surviving monies are those that acquire broad use cases. Still purely a speculative tool, and possibly one useful in evading capital controls, bitcoin has so far failed to fulfil any one of the three fundamental monetary functions: it is not (yet) useful as a medium-of-exchange; it has not (yet) demonstrated it is a reliable store of value; it has not (yet) been adopted as a unit of account.
The key word here is ‘yet’, and I fully admit that only time will tell. But whereas bitcoin may, or may not, eventually find a broad range of use cases as a final means of settlement, gold has been accepted as such for millennia and remains so today. In preparing for the coming stagflation, therefore, I would be overweight gold, while keeping an eye on bitcoin primarily as a speculative play.
John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)