The Dollar Has Peaked – Part I

The past week has seen a sharp decline in the US dollar, both versus major currencies and in broad, trade-weighted terms. While this could be a mere technical pullback, I believe there is a strong possibility that this is the beginning of a large move of 10% or more. While that would be a sizeable decline, it is hardly without precedent. Indeed, the history of the dollar demonstrates that it tends to rise slowly and steadily over long periods yet declines sharply if more briefly. Those who follow financial markets closely know that this is how ‘risk assets’ in general tend to trade. While the dollar is not considered to be a risk asset, I do believe that it has risk characteristics, and it is primarily this framework that I apply in this series.

Both Trade And Financial Flows Impact The Dollar

My view of dollar weakness is a long-held position. A year ago I thought the dollar would be weaker vs a basket of 50% gold and 50% other currencies. But this has not played out. Gold is far stronger, having risen by over 20%, but the currency basket, however, was slightly weaker, if you include the Norwegian krone, which declined sharply along with oil prices earlier this year. Whether the dollar has been strong over the past year or not thus depends largely on how it is defined.

The rationale to Include the Norwegian krone, alongside the Japanese yen, Swiss franc and Singapore dollar, reflects my view not only that the trade-weighted dollar was strong in a historical comparison—it was and still is—but also that the dollar benefited disproportionately from historically large inflows into risky assets such as high-yield corporate and emerging market debt, the vast bulk of which—80% by some estimates—is denominated in dollars. I believed that risk premia were unreasonably compressed in 2019, and therefore that risk asset valuations would need to adjust lower in general; then, as they corrected, they would likely drag the dollar along, at least to some extent.

In my opinion, in such a scenario the primary beneficiaries of dollar weakness would be the so-called ‘surplus’ currencies; that is, those running large current account surpluses. Surplus currencies tend to behave as safe havens, safer than the dollar in any case, in a generally risk-off environment. Gold, as the safest ‘money’ of all, would likely perform even better.

Financial flows also matter. The stock of dollar-denominated debt has risen sharply in recent decades leaving dollar debts harder to service in periods of tightening in US monetary conditions . The demand for dollars in circulation therefore outstrips supply, pushing up the dollar’s value in the foreign exchange markets. The sheer weight of dollar debt and leverage in the global financial system can result in a spontaneous tightening of dollar monetary conditions even with the Fed on the sidelines.

But the Fed’s reaction function to the sort of dollar squeeze described above is not constant. There have been squeezes before, including in late 2008 and, more recently, late 2014/early2015. But in the former case, all the dollar’s gains were quickly given up once the Fed stepped in with extraordinary policy measures, thereby reversing the dollar squeeze. In 2014-15, by contrast, the Fed was on a deliberate taper-tightening course in any case and so had no reason not to welcome dollar strength.

Now, which of those two fairly recent periods seems a better parallel with today? I strongly suspect the former. While we are hardly in the midst of a full-blown financial crisis, the Fed was already de facto easing policy last year when stress appeared in the repo market. This year’s Covid scare shouldn’t distract us from what were already signs of incipient financial stress. I have no doubt that, had the Fed sat on the sidelines, the dollar would have squeezed even higher than it did at the time.

The Powell Fed Shows Its Hand

Now that the Powell Fed has shown its hand, we can see that it is essentially the same one previously played by Greenspan and Bernanke, both of whom repeatedly took extraordinary actions to avert sudden dollar squeezes during their respective tenures. With the notable exception of the years 1996-2002, the dollar trended lower from the Plaza Accords in 1985 to the historical low reached in 2012.

My long-held view is (as long as measured inflation remains reasonably low—say under 5% y/y) that the Fed will not hesitate to do its own version of ‘whatever it takes’ to prevent a systemically-destabilising dollar squeeze. It might even act pre-emptively, as is the case today. Other factors equal, the dollar should then decline anew. Perhaps we are seeing the start of that now.

There are numerous other, more mainstream arguments for why the dollar should remain strong. These tend to tout the US’s relative economic advantages over other countries, the ‘cleanest dirty shirt’ argument as it were. For example, Japan has demographic and associated debt sustainability problems; Europe seems to be mired in a perpetual banking crisis from which there is no escape; the UK runs chronic trade and budget deficits even larger than the US on a GDP basis; commodity producers such as Australia, South Africa or Canada are directly exposed to the global business cycle, which may have turned as China slows, etc.

While I would not presume to deny any of the above, what bothers me about such factors is that they are so well known as to be indisputable. In my experience, indisputable facts do not drive financial markets, which are all about changing expectations, speculation around changing expectations, and the risk appetite therefor. John Maynard Keynes was a brilliant if in some respects misguided political economist, but his description of financial markets as a speculative ‘Beauty Contest’ were spot on in my opinion. The strong dollar, as it were, is ‘fully priced’ and, if risk assets should sell off again, and the Fed steps in to reliquefy the system, I am confident that the dollar will re-enter a downtrend.

Traditional Models Fail To Capture Today’s Highly Financialised Economy

The global economy and associated asset and liquidity flows are an order of magnitude higher relative to underlying trade in goods and services than in decades prior. Traditional foreign exchange models based on real-effective exchange rates, or purchasing-power or plain-vanilla interest-rate parity, are unlikely to capture what is really decisive in a highly financialised and globalised world, the central currency of which is the dollar.

It part II of this series, I will update and apply an asset-centric foreign exchange framework I developed all the way back in 2000, when dollar strength alongside the US tech bubble crash was a surprise to many, including me, and led me to examine more closely the role that asset markets play in determining foreign exchange rates.

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.)