Shifting Gears: US Dollar on a Downward Trajectory

The outlook for the US dollar changed in July, evidenced by the 4% drop in the greenback versus the G10 basket during the month. To add some historical perspective, the US dollar typically loses around 3%-4% per year for 7 to 10 years in a bear market cycle – we experienced that change in one month. What explains this change?

In our view, investors began to recognize the implications from the resurgence of COVID-19 – the likelihood of a protracted and uneven economic recovery and an outside chance for the loss of the US dollar’s dominance as a reserve currency. In short, the longer-term dynamics and interest rates have shifted to favor a US dollar bear market and the economic and election headwinds have accelerated that shift. Our case is as follows:

US Dollar Started From a High Point

The US dollar tends to move in 7-10-year cycles, which produce broad swings of at least 30%-40% in the currency’s value. The latest bull market entered its tenth year in 2020 and reached a peak in March, posting a 40%-plus gain from its 2011 low in the Bloomberg Dollar Index. The duration of the cycle plus the pattern of historically low interest rates (prior to the virus) meant that the US dollar was expensive relative to its long-run fair value. In a nutshell, relative interest rates already favored a US dollar peak with the risk of a looming bear market.

US Faces New Economic Headwinds and Election Risks

The resurgence of COVID-19 in several large states has put paid to hopes of a faster economic recovery. Various economic forecasters and the US Federal Reserve (Fed) now think that the economic recovery would become more protracted and riskier than initially expected. One reason behind the revised outlook was the fractionalized, state-by-state (if not county-by-county) response to the virus. In other words, the US response began to be perceived globally as weak relative to the success of the more coordinated responses in Europe and Asia.

Adding to the negative investor perspective on the United States (US), Democratic presidential candidate Joe Biden pulled ahead in the polls. The prospect of a Democratic victory in the presidential election or even a sweep of the congressional races raised investor concerns about increased regulation and new taxes, particularly on the corporate sector. If enacted, these would reduce earnings expectations and encourage capital outflows to the detriment of the US dollar.

Making matters worse, President Donald Trump has begun to question the integrity of the upcoming election in light of the likely increase in mail-in voting. The election was already expected to be quite contentious given the deeply divided electorate and the potential for a disputed election only served to further increase the political risk premium in the US dollar.

Near-Zero Interest Rates Signal Dollar Depreciation

Before the Fed pivoted to a zero-interest rate policy, US short-term yields were higher than the policy rates in Europe and Japan. But after March 2020, the interest rate gap narrowed significantly, and the rate will remain at or near zero for at least 2 to 2.5 years given the virus-related economic headwinds and a pessimistic outlook from the Fed. The nearly open-ended commitment to quantitative easing and other monetary tools is another long-term negative factor for the currency.

Incentives Favor Hedge-Related Selling

At present, the incentives for international investors have shifted meaningfully toward an increase in hedge ratios, which involve significant US dollar selling. Just 12-18 months ago it cost European and Japanese investors at least 2%-3% to hedge US assets. Since the US dollar tended to hold up well during equity markets sell-offs, the unhedged US dollar position used to provide some measure of equity downside protection (albeit not so much for Japan-based investors). Now, the hedging calculus has changed. Global yields have converged toward zero and the cost of hedging is very low – under 30 bp for a Japanese investor, 65 bp for a European investor and only 6 bp for a UK-based investor.

The potential for downside diversification has also reduced. The truly explosive moves higher in US dollar during a crisis, such as the one in March 2020, tend to happen when there is a US dollar funding crisis. But central banks led by the Fed have flooded the US dollar funding markets with liquidity via cross-currency swap lines. This excess liquidity not only further reduces the cost of hedging but also helps in limiting the potential for US dollar upside in times of crisis.

Another important factor is the broader monetary and fiscal support, which will help alleviate downside risks in financial assets. To be sure, we expect periods of volatility, but the policy support infrastructure in place should prevent undue surprises. With lesser diversification benefits from holding unhedged US dollars, worries about the headwinds faced by the US as well as much lower costs of hedging, why not increase hedges? Or, if you are a US investor, why not reduce foreign hedges?

US Dollar Unlikely to Lose Its Reserve Currency Status

While we expect a transition to a US dollar bear market, we do not see the greenback losing its reserve currency status any time soon. However, such a possibility warrants discussion as it will weigh on US dollar sentiment and trigger bouts of volatility.

Global investors may lose confidence in the US dollar due to a combination of factors: the growing US fiscal and current account deficits; higher future taxes restricting capital available for private investments; the US dollar’s reserve status being instrumentalized for financial sanctions; and the Chinese renminbi gradually taking a greater role in the global financial system. Each of these factors has become modestly more valid than in the past.

In practice, displacing the US dollar as a reserve currency would take a long time since the US dollar is imbedded in global business and trading activities as the principal invoicing currency, financing currency and global reserve. In addition, switching to a multi-currency world assumes an increase in the cost and complexity of managing several currency exposures. This means, the benefits of choosing an alternative reserve currency or currencies would need to be significant enough to provoke such a paradigmatic shift.

At this time, we do not see a clearly better alternative for the next cycle. The euro has negative yields, a distinct disincentive to holding it, and the long run future of the currency is still in doubt. The renminbi, on the other hand, is heavily restricted and, if anything, the developed world is growing more concerned with China’s trade and economic policies. Beijing’s control over its currency and financial markets are unlike to change.

This is in contrast to the US, which continues to have the largest and freest capital markets in the world – one important reason why the US dollar would continue to remain as the preeminent reserve currency of the world. Correspondingly, we think that the twin deficits at this point do not push the US anywhere close to a severe credit event, and as a result, it is hard for us to see a doomsday scenario developing anytime soon.

Investment Implications

We recommend that long-term investors and strategic currency hedgers begin to position themselves for a new bear market cycle in the US dollar. As pointed out above, a US dollar bear market cycle is a long-lived affair – in the range of 7 to 10 years – and usually starts slowly. We do not anticipate a runaway, one-direction move lower considering the global uncertainties of COVID-19, potential short-run volatility and the power of monetary and fiscal stimulus to goad economic growth. In the end, we expect a combination of strategic shorting of US dollar, limiting positive US dollar positions and short-term tactical moves to serve investors well. 

In our view:

• Non-US dollar based investors could increase their strategic dollar hedges
• US-based investors could reduce foreign currency hedges and book profit after a decade of hedging gains
  
• Risk-averse investors could buy the Japanese yen against the US dollar – this should provide a conservative way to gain exposure to a dollar bear market while hedging risks of market volatility
• Gold may also serve this purpose as it tends to do well in times of crisis and during US dollar bear markets
  
• Equity investors should carefully consider the impact of sustained US dollar weakness on company earnings