The dollar could lose some of its shine

After appreciating steadily over a several-year period, the US dollar is facing a growing number of factors that might just tip the scales in the opposite direction. Market movements over the last eight weeks underscore the need to examine that eventuality.

The dollar itself is highly sensitive to changes in risk appetite and, due to its global role, it is a particularly complex instrument

Disparities in how governments have handled the Covid-19 pandemic and in their fiscal policies suggest that the various economic blocs will recover at differing paces.

The United States stands out on all counts. No less than 60% of the adult population has been vaccinated to date, the economy has snapped back and fiscal and monetary policy stimulus is impressively large. Yet since the end of the first quarter, nominal interest rates have held fairly steady, the equity-market rally has slowed and the dollar has depreciated to the point that it now stands roughly where it was at the start of the year. This paradox is less surprising than it looks at first blush, however.

Both macroeconomic data and corporate earnings releases in the country bear witness to a sharp economic upswing¹. Moreover, the Biden administration’s proposed budget – with spending plans to the tune of $6 trillion dollars in 2022 – suggests the US economy will still be growing at a solid pace beyond this year of recovery.

Though such high economic growth, both in absolute terms and relative to the rest of the world, typically goes hand in hand with a rising currency, the greenback has already surrendered most of its first-quarter gains.

This is partly down to the problem that how Congress ultimately votes is often at odds with what the President wants² . But more importantly, Biden’s leaning towards transfer payments, which would tend to support consumer spending rather than capital expenditure leads us to believe that the return on investment will likely be lower than in the past. And that will make dollar-denominated assets less attractive.

This changed reaction function at the Fed, which boils down to letting inflation pick up steam before intervening, has an impact on the greenback.

It should be recalled that inflation erodes the time value of a currency, and therefore in this case the demand for US dollars: rising prices mean that you’ll get more goods and services for one dollar today than you will tomorrow. And ever since the US exited the gold standard in 1971, currencies are sustained primarily by the degree of confidence the corresponding central bank commands. Janet Yellen’s appointment at the head of the Treasury thus heightens the existing doubts as to how fully independent the Fed actually is. The US central bank’s plan to finance a sizeable share of the country’s record fiscal deficit may raise some eyebrows⁵ . To make matters worse, part of the shortfall will have to be paid for with higher taxes. And the deteriorating current account will likely fuel consumer spending rather than capital investment. That is bound to undermine a currency already weakened by a combination of fiscal and trade deficits and by the pandemic-induced erosion of an interest-rate differential that has worked to the advantage of the United States for so long.

Then again, we could be in for something much worse: “stagflation”. This portmanteau was coined when the golden age of Keynesian economic policy in the mid-1960s, based on fiscal largesse pursued in cahoots with central bankers, was on its way out. (Needless to say, any resemblance to recent events is “purely coincidental”.) Those who harbour stagflation fears can indeed point to the latest US non-farm payroll reports, which surprised to the downside⁶. A probable explanation for this hiccup is that, flush with generous benefits, some of the unemployed seem to be in no hurry to look for a job at this stage. This could result in an upward drift in wages as companies struggle to attract workers – even though that struggle may not reflect a more robust economy. Rising pay levels are among the key possible drivers of more lasting inflation and could also rekindle fears of a wage-price spiral. Both monetary policy and fiscal policy are fairly ill-suited to overcoming such a predicament. What makes this a Catch-22 situation is that efforts to boost GDP growth tend to fuel inflation, whereas orthodox policies aimed at keeping inflation in check tend to stifle growth. The upshot is an unpalatable cocktail for a country’s currency and economy.

These various forces are likely to weigh on the dollar in the medium term.

When it comes to investing, what distinguishes foreign exchange strategies is that they revolve by definition round a currency pair, and identifying the right counter currency is always a tough call.

Although Europe has been more severely affected by the Covid-induced downturn and has less impressive stimulus policies than the US, the region has become more attractive to international investors, not only because political cooperation has strengthened, but also because a large number of issuers here are poised to cash in on an economic recovery⁷. This is the first time in quite a while that European equities have outperformed their US counterparts without being hindered by euro appreciation. Moreover, this trend stands a good chance of continuing. Eurozone inflation expectations have risen⁸ but are still far below the ECB’s target rate (contrary to the situation in the US), and they could be further buoyed by the region’s comparatively more favourable growth momentum, as economic re-opening has only just begun.

Furthermore, European interest rates have been climbing noticeably this spring. In fact, investors even appear to be pricing in monetary policy tightening over the next two years and possible tapering of the ECB’s extraordinary asset purchase programme. We feel these investors are jumping the gun, however. At this point, inflation is primarily a US issue, and we expect both the ECB’s policy timetable and the future statements by its members to remain dovish. European interest rates can therefore be expected to stall.

China has handled the pandemic much better than the United States. But the country is also rendered attractive by the improving long-term economic and technological outlook for the region as a whole. China has continued to invest in the technologies shaping the future. The yuan has risen significantly, reflecting both good macroeconomic news and the interest-rate oasis that China offers in an otherwise yield-starved desert. And for the time being, Beijing seems to have adopted a somewhat permissive stance on such movements – sensibly, as a stronger currency is an effective way to limit the extent to which the US inflation fuelled by Fed policy will be imported. Even so, the Chinese central bank is likely to stick with its dovish stance to prevent the currency from appreciating too sharply against the dollar, and that should keep the country’s equity and bond markets humming. The simmering tensions with the United States are the main potential source of disorder.

Those performance drivers are being supported by key strategic hedges. As described in our recent Notes, interest-rate risk is one key focus of that approach. And as we’ve hinted at in this paper, currency risk is the second. Though it may seem counterintuitive, a weaker US dollar is not antithetical to higher interest rates. And just as with interest-rate risk, managing currency risk calls for an active approach. The dollar itself is highly sensitive to changes in risk appetite (both upward and downward) and, due to its global role, it is a particularly complex instrument that is prone to short-term movements.

Source : Carmignac, Bloomberg, 07/06/2021

¹In the first quarter, US GDP growth came in at 6.4% on an annualised basis. Corporate earnings per share were up 50% year-on-year, overshooting what were already quite bullish forecasts.
²Given how slim the Democrats’ majority in Congress is, getting laws passed will hardly be a stroll in the park for Biden.
³Chairman Powell and his Board of Governors have managed to convince investors that they won’t be shifting gears any time soon, that the current price increases are transitory and that there is therefore no compelling reason to start tightening policy yet.
⁴At over 4% year-on-year, the inflation rate currently exceeds consensus forecasts and stands higher than at any time in the past decade.
⁵The Fed will be hoovering up some 25% of all new Treasury issuance this year.
⁶The April report showed 278,000 jobs created, versus a median estimate of over 1 million. The figure for May was 559,000, compared to an estimated 675,000.
⁷These issuers include consumer-goods and travel-related companies, along with “old economy” businesses in manufacturing, banking and commodities.
⁸Average expected inflation for the next 10 weeks is 1.4% for the eurozone, versus 2.4% for the United States (or one percentage-point higher for the next 10 weeks, year-on-year).