Implications Of A Stronger U.S. Dollar by Matthew Cobon, ColumbiaManagement
- The U.S. dollar could continue to perform well, but there is a short-term case as to why dollar strength could be accompanied by more asset class volatility.
- Currency markets are moving ahead of what interest rate markets are telling us, so there is a disconnect. Things could become very challenging for the Fed if the U.S. starts importing deflation from elsewhere.
- The asset class volatility argument is related to global liquidity being withdrawn and the dollar (as a reserve currency) taking the mantle as the ‘safe haven’ of choice.
Looking at the long-term history of the U.S. dollar, it is worth remembering that inflection points for the currency have frequently occurred around ‘big picture’ events. Under Chairman Paul Volcker, the Federal Reserve (Fed) moved aggressively to counter the boom/bust tendencies of the 1970s; the Fed raised interest rates aggressively, which, after a lag, led to a remarkable rally in the dollar. This ended with the 1985 Plaza accord when the G6 decided that enough was enough and targeted the currency, resulting in a large fall in the dollar in the 1980s. This, in turn, led to the 1987 Louvre accord, which was intended to stem the dollar’s decline (albeit without much success). It was only when the Fed started raising rates again that the dollar responded, albeit temporarily. The early 1990s saw another sell-off.
The benign period for the dollar started in the mid-1990s as investors moved to buy ‘U.S. Inc.’, which culminated in the formation of the dot com bubble. What has become known as the ‘great carry’ era started after the dot com bust, and finished at the end of 2008 when there was a liquidity-induced squeeze in the dollar.
Recently, the dollar has been performing well; at the time of writing, the dollar index is up nearly 7% since the beginning of May 2014. Although it was battered by QE, the dollar now appears to be trending higher. The risk, in my opinion, is that fixed income markets do not appear to validate this view. Much of the Fed’s monetary tightening (in the form of interest rate rises) could end up taking place via the currency. At the moment, currency markets are moving ahead of what interest rate markets are telling us, so there is a disconnect. It could certainly be more difficult for the Fed to consider raising interest rates if the U.S. begins to import lower prices for goods and services from other regions where economic growth is slowing, such as the Eurozone, where deflation concerns have recently re-emerged.
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The clear positive for the dollar is that the U.S. economy is an attractor of capital; the shale gas revolution is the important driver here and is changing U.S. politics and economics. The U.S. current account (as a percentage of GDP) is very benign and continues to shrink. Net oil imports required by the U.S. have shrunk from around nine million barrels a day to less than two million barrels a day, and the shortfall could be eradicated in the next couple of years. These positives underpin our favorable strategic view on the dollar.
What else can history tell us about the dollar? If we look at the broad dollar index and U.S. interest rates, it is interesting that the rates cycle historically tended to lead the currency, i.e. interest rate rises had to come through before the dollar reacted. This time the dollar has reacted even though rates haven’t gone up yet; this might be because of QE, and also perhaps because Fed tapering has been taken by the market as the first sign of tightening.
Implications for other asset classes
There are a number of asset classes which historically have struggled in periods of dollar strength. EM assets in particular tend not to like a strong dollar, and emerging market bonds are one area that could struggle in my view, particularly if liquidity does begin to tighten.
It is also worth pointing out that volatility in currency markets tends to lead to volatility in other asset classes; the correlation here tends to be quite strong over time. Currency volatility, as referenced by the CVIX index of currency volatility, is still very low but has risen by about 50% from its lows in July 2014. This is worth watching, especially if it turns out to be driven by liquidity issues (or the pricing out of liquidity), rather than the more benign divergence of the U.S. economy versus the rest of the world.
Strategically, we still feel positive on the dollar, given the improving U.S. current account and the significant benefits of U.S. energy independence, but the extent of the dollar rally this year probably means that much of the easy progress for the currency has already been made.
Threadneedle International Limited is an FCA- and a U.S. Securities and Exchange Commission registered investment adviser based in the UK and an affiliate of Columbia Management Investment Advisers, LLC.