- The breakdown of the Eurodollar funding system has driven the dollar stronger in recent months but this has come at the expense of future returns.
- The correlation between the dollar and real interest rate spreads suggests ~30% dollar declines vs. a basket of the EUR, GBP, EUR, and AUD over the next two years.
- The desire to keep financial assets elevated, rising levels of government debt, and high external indebtedness suggest the Fed and Treasury will drive real rates further negative.
- As foreign investors become less willing to fund perpetual increases in U.S. external debt, a large decline in the dollar will be needed to allow exports to rise enough to close the current account deficit given the U.S.’ hollowed-out manufacturing sector.
The outlook for the dollar is arguably the most hotly debated topic in the global macro space. It is at the heart of key issues such as the outlook for inflation vs. deflation/inflation and getting the dollar call right will be crucial to determining how investor portfolios perform over the coming years.
We are firmly in the bearish camp for reasons explained below. While bullish arguments such as a global dollar shortage and structural global demand for dollars sound intellectually appealing, our view is that they rest on faulty assumptions and bad economics. Crucially, they ignore the most important driver of currency moves over the short and long term – real interest rate spreads – which are increasingly dollar-negative.
Understanding The Dollar Bull Case
The bullish argument goes something like this: foreign (ex-U.S.) banks and non-banks have created trillions of dollars of loans over the past decade through the Eurodollar system, to the tune of USD57trn by some measures. Foreign banks have created dollar liabilities but cannot create dollar-based money to cover those liabilities, so the argument goes. These dollars must therefore come from further Eurodollar loan creation but the collapse in global trade has reduced the willingness and ability of banks to create these loans. This has created a mismatch between demand and supply of dollars, or an effective dollar shortage.
They argue that the increase in Fed debt monetization and introduction of swap lines in March pale in comparison to the size of Eurodollar liabilities and the fact that the dollar has barely weakened since these measures were enacted is a testament to this. Once central bank swaps are reversed and central bank reserves begin to decline, the real dollar rally will begin as the Fed will not be able/willing to create the volume of base money required to satisfy demand, sending the dollar much higher.
Understanding The Dollar Bear Case
The bearish case holds that while Eurodollar funding halt triggered the dollar’s recent surge, this will ultimately give way to weakness as global trade stabilizes, the U.S. Treasury and Fed continue to issue and monetize debt at a record pace, and any resurfacing of short-term dollar liquidity needs can be met with swap line withdrawals and/or direct reserve sales. U.S. policymakers stand ready to address any Eurodollar funding needs as they must avoid a collapse in domestic asset prices to prevent a domestic debt-deflation spiral.
As the Treasury and Fed continue to issue and monetize debt, real interest rates will drive deeper into negative territory, triggering a reduction in dollar hoarding by U.S. and international investors, including central banks. The U.S.’ huge external debt load and hollowed-out manufacturing sector mean that even a marginal reduction in dollar demand could wreak havoc on the U.S. economy, necessitating a much weaker dollar. The fact that the dollar has weakened despite swap line usage representing just 5% of global central bank dollar reserves suggests that the dollar short squeeze has given way to its structural decline.
Critiques Of The Bullish Argument
Bullish argument: There is a global shortage of dollars. Critique: The dollars still exist, they are just temporarily being hoarded.
The Eurodollar system created trillions of dollars’ worth of loans, but it also created the dollar deposits alongside them which remain held by someone. These dollars are simply being hoarded by individuals, corporations, and banks who are currently unwilling to lend them due to the weak economic climate and the crash in commodity prices. The real issue at play is not the amount of dollar liabilities but the fact that these liabilities require interest payments which the Eurodollar system is currently not able to create. As explained below, we see every reason to believe that the Fed is up to that task of providing dollars to meet these needs.
Bullish argument: The flow of USD from the U.S. to the rest of the world needs to be sufficient to meet the inbuilt demand for trade and other transactions. Critique: This inbuilt demand is not guaranteed and it would take only a marginal reduction to trigger sharp dollar declines.
Dollar bulls argue that if the U.S. reduces its imports and closes its current account deficit this would exacerbate the shortage of dollars outside of the U.S. However, the U.S. current account deficit is a reflection of the fact that foreign investors and central banks have been willing to hold dollar assets, to a large degree in the form of Treasuries as a store of value. If foreign investors realize there are much better investment opportunities available, the dollar will weaken as the U.S. current account deficit is forced to narrow.
Bullish argument: Lower commodity prices are dollar bullish because they reduce the flow of dollars to commodity exporters. Critique: Lower commodity prices reduce the amount of extant dollars going into the commodity exporting countries’ reserve hoards but increase the amount going into the hands of investors with a higher propensity to invest them in better stores of value.
Back when oil prices were high, most of the world’s oil purchases would find their way into the reserve stockpiles of oil exporting central banks which were almost guaranteed to invest them in U.S. Treasuries without much of a thought for the return prospects. The drop in spending on oil has not reduced the amount of dollars in the global economy, it has merely changed what these dollars are spent on. Instead of recycling them blindly into Treasuries, dollar holders are increasingly likely to look for better return prospects. Additionally, as explained previously (see ‘3 Reasons Low Oil Prices Are Dollar Negative‘) lower oil prices are also much more positive for the growth outlooks of the U.S.’ trading partners as the U.S. is no longer a net oil exporter.
Bullish argument: Central banks don’t have nearly enough reserves to offset the amount of debt they owe. Critique: Countries do not need central bank reserves in order for their currencies to strengthen. In fact, large reserve sales often mark the end of EM currency depreciation.
Dollar bulls argue that countries with high levels of dollar debt and few reserves face major problems but the fact of the matter is that many of the U.S. trading partners have dollar assets that exceed the level of liabilities, also known as net international investment surpluses. Even if the Bank of Japan’s reserves fell to zero, the Japanese private sector would still have a surplus of dollars in excess of USD2trn that could be sold in exchange for local currency. Furthermore, once foreign central banks begin to engage in reserve sales, their currency weakness often tends to be almost over already. Like politicians, central bankers are reactionary in nature and begin to sell reserves to support their local currencies only after they have already depreciated significantly and are ready to recover.
Dollar Strength Has Sowed The Seeds Of Its Own Decline
The breakdown of the Eurodollar funding system has been the driver of the upside pressure on the dollar since the oil price crash/corona lockdown as dollar hoarding has prevented indebted corporates from rolling over their loans in the Eurodollar market. However, as the dollar has strengthened its fundamental outlook has deteriorated. To prevent further dollar strength, the Fed has forced down real interest rates undermining its medium term outlook.
Dollar Fair Value Is ~20% Below Current Levels
The chart below shows the performance of the dollar versus a basket of the EUR, JPY, GBP, and AUD – the four most actively traded currency pairs – alongside our measure of fair value based on real interest rate spreads between the U.S. and an average of Germany, Japan, the U.K. and Australia. For real interest rate spreads we use 10-year inflation-linked bond yields. From trading around fair value in mid-2019, the dollar began to decouple in H219 becoming almost 30% stronger than its fair value at its peak on March 20. Since then we have seen dollar weaken while its fundamental drivers have moved even more negative.
Source: Bloomberg, analyst calculations
This will surely be seen by dollar bulls as evidence that old rules no longer apply. However, the current divergence bears striking similarities to early 2009 as similar forces triggered a surge in the dollar despite deteriorating fundamentals which ultimately sowed the seeds of its own decline. The chart below shows the tight historical correlation between the dollar’s deviation from fair value and dollar performance over the subsequent two years in total return terms. The dollar is now priced to lose over 30% over the next two years.
Source: Bloomberg, author calculations
3 Reasons U.S. Real Rates Will Continue To Decline
We would be less concerned by the dollar’s decoupling from real interest rate spreads if we saw prospects for U.S. real rates to reverse their recent declines. However, we actually think there’s a strong likelihood that U.S. real rates head more deeply into negative territory, leading to further declines in spreads relative to its trading partners. This view is based on three very important factors: The desire to keep domestic financial assets elevated, high and rising levels of government debt, and the high proportion of U.S. debt held by foreigners.
1) Policymakers’ Obsession With Financial Asset Prices: U.S. policymakers have become obsessed with keeping asset prices elevated and are therefore highly likely to look to prevent deflationary dollar strength from bursting the bubble in U.S. stocks. We estimate that U.S. stocks could be as much as 5 times overvalued based on the decline in valuations that would be needed to suggest long-term returns match their historical 6.5% real return figure. We have little doubt that real returns on U.S. stocks will be devastatingly poor, but policymakers will fight tooth and nail to try to prevent sharp nominal declines. As we show here, U.S. stocks are far more expensive relative to most of the rest of the world and will face significant headwinds which will force policymakers to continue easing in an attempt to support nominal prices.
2) High And Rising Public Debt: Even before the COVID-19 outbreak, the U.S. government showed no signs of narrowing its fiscal deficit let alone bringing down its stock of public debt. Republicans favour tax cuts and Democrats favour spending increases, with the only consensus being that deficits should not be closed. The implication is that deficits will remain in high single digits as a share of GDP for the foreseeable future. Of course, the rest of the world is also running fiscal deficits at present but there have at least been some efforts in recent years by politicians outside the U.S. to engage in fiscal austerity. As explained in ‘The Coming Stagflation And The Case For Silver‘, fiscal deficits are the primary cause of inflation, particularly when accompanied by central bank debt monetization. The U.S.’ relatively poor fiscal position will not only lead to higher inflation acting as a direct drag on the dollar, but it will also ensure that the Fed keeps real rates deeply negative to prevent interest costs from rising, further undermining its fiscal position.
3) High Foreign Debt Ownership Adds Insult To Injury: The U.S.’s high debt levels would be far less of a concern if, as in the case of Japan, this debt was held by U.S. residents. The fact that foreigners own a large share of both public and private debt should be particularly concerning to dollar holders. Official foreign holdings of U.S. debt currently amount to USD6.7trn at the end of 2019, equivalent to 31% of U.S. GDP, while foreign holdings of debt other than Treasuries amount to another 26% of GDP. On top of this, foreigners hold a combined 29% of GDP worth of loans and currency and deposits, as well as an additional 8% of GDP worth of direct investment debt instruments. In total, the U.S. has debt-based liabilities equivalent in size to its entire economy.
Balance of payments data show that in 2019 the U.S. paid a total of USD482bn in interest payments through its primary income account, equivalent to 2.2% of GDP, despite near-record low interest rates. A 1 percentage point increase in interest rates would equate to almost 1% of GDP outflows from the U.S. economy per year, which is likely to exceed any growth in real GDP over the coming years as outlined here and here. The upshot is that the Fed will be forced to keep real rates deeply negative to prevent an even further rise in external indebtedness.
Debt-To-GDP Ratios Understate The Risks To The U.S. Economy And Dollar
Comparing debt to GDP actually greatly understates the extent to which the U.S. economy and the dollar are at risk from even a marginal reduction in demand from foreign holders of U.S. assets. A more important metric is external debt to exports. Because exports are such a low share of U.S. GDP, if foreign investors decide merely to not increase their net holdings of U.S. assets, therefore forcing the U.S. to run a balance in its current account, exports will have to rise substantially to prevent a painful contraction in imports.
With exports totaling roughly 12% of GDP in 2019 and the current account deficit totaling 2.3% of GDP, exports would have to rise by fully 20% to prevent a decline in imports. As the U.S. is heavily dependent on imports for essential goods, the economy would need to undergo a dramatic shift to balance its current account, with savings rates being forced to rise sharply and/or investment collapsing. Needless to say, the dollar would have to decline dramatically in order for this shift to take place.
Currency Valuations Further Suggest Declining U.S. Competitiveness
This brings us to the importance of currency valuations and what they imply for the dollar. Over a multi-year period, currency valuations tend to mean-revert, meaning that if real currency values become expensive they will face depreciatory pressure and vice versa. Part of the reason is that strong real currency values undermine external competitiveness and lead to increases in external debt. This is exactly where the U.S. finds itself at present. Its real effective exchange rate is significantly above its long-term average and based on its historical relationship with future returns, the dollar is currently priced for ~15% declines over the next decade.
Source: BEA, Bloomberg, author’s calculations
The Economist’s Big Mac index provides further evidence for the dollar’s overvaluation. Used as a proxy for general price levels, the index shows that currently only Switzerland has more expensive burgers than the U.S., while most developed countries are at least 10% cheaper. This contrasts dramatically with the case a few years ago.
Big Mac Index
Source: Bloomberg, The Economist
Interest Rate Returns Should More Than Offset Spot Declines In EM FX
While we are bearish on the price performance of the dollar versus most developed market currencies, emerging market currencies will likely continue to experience nominal depreciation owing to higher rates of inflation. In total return terms, however, these currencies are likely to perform the strongest. Since 2000, despite EM FX declining by 50% in spot terms, higher interest rates relative to the U.S. have more than made up for this nominal loss resulting in 100% gains in total return terms. As explained here, despite higher inflation levels, real interest rate spreads across emerging market currencies are at multi-year highs while real exchange rates are at multi-year lows. This combination of factors suggests considerable outperformance in total return terms, particularly as U.S. real interest rates head more deeply into the red.
Source: Bloomberg, JPMorgan