I’ve received a few questions about the recent drop in the dollar. Currencies can be a complicated subject, but I’ll try to make the topic a little easier in today’s Market Commentary.
Director of National Economic Council Larry Kudlow likes to refer to the US currency as “King Dollar.” Indeed, as shown in the chart below, the dollar has earned that moniker in the decade following the Global Financial Crisis. The appreciation in the dollar reflected a number of factors. Most notably, the Federal Reserve acted forcefully and decisively in supporting the domestic economy in the aftermath of the crisis. Not only did the central bank cut short- and long-term interest rates through aggressive monetary policy, but it also oversaw a recapitalization of the banking system. At the same time, the US government has been fairly aggressive in stimulating the economy through fiscal policy, including tax cuts and increased government spending. All of these actions, which were above and beyond anything we saw in other countries, restored confidence and served to boost economic growth in the US to an average rate of about 2% – nothing to write home about but quite robust compared to economies like Europe and Japan. In stable economic times, money will flow into economies that offer the highest growth rates and investment returns. One need only look at the outperformance of US stocks over the past ten years for proof that investing in the US has been a winning strategy.
Another reason the dollar has been so well-bid over the past decade is that interest rates in the US have been significantly higher than in most other major economies. Higher rates in the US reflected the expectation of superior economic growth as well as positive inflation. Economies in Europe and Japan, on the other hand, have struggled to post any growth at all while also battling bouts of deflation. All else equal, investment dollars will flow from low interest-rate economies to higher interest-rate economies through a trading strategy known as the “carry trade.” Why earn zero interest (or less) on Japanese and European government bonds when you can earn 2% on US Treasuries? Traders sought to profit from that dislocation by borrowing in foreign currencies and investing in the US, thereby boosting demand for the US dollar.
You may have heard that the dollar serves as the reserve currency to the world. The dollar’s status reflects a number of factors, including the sheer size of the US economy as well as our economic and political stability, among many other factors. Because of the dollar’s status as reserve currency, there is a baseline level of demand for dollars from foreign central banks holding reserves, global businesses conducting international trade, and anyone buying commodities (which are generally traded in dollars). The dollar’s status as reserve currency also means that in times of crisis, the dollar is viewed as a safe haven. Periodically throughout the past ten years we’ve encountered crises that precipitated a flight to the safety of US dollars. The European debt crisis, the trade wars with China, and the saber rattling with Iran and North Korea come to mind. Whenever investors get scared, demand for dollars spikes.
Why the Sudden Dollar Weakness?
The easiest explanation for the pullback in the dollar is that the dollar had been so strong for so long that it is now reverting back closer to the mean. Indeed, even after the recent drop, the dollar is still quite a bit higher than it was in the first half of the decade. But such a simple explanation is obviously inadequate. Given the discussion above, I can think of several reasons for the dollar’s recent correction:
- The Fed wants to see a weaker dollar, and so it is jawboning relentlessly to get what it wants. But why would the Fed want a weaker dollar? First and foremost, the Fed wants the dollar to weaken because it is inflationary. When the dollar is falling in value, commodity and import prices rise, and those price increases can lead to more widespread inflation throughout the economy. The Fed has been trying to boost inflation for the past decade because a little inflation encourages consumption and investment in the here and now (versus deferring action into the future), and therefore it is supportive of economic growth. Inflation will also help US businesses, consumers and governments better manage huge amounts of debt that have accumulated over the past 10 years. A second reason the Fed wants the dollar to fall is that a falling dollar helps US businesses to become more competitive in the international marketplace. If US companies can better compete, more US jobs are created. And finally, a falling dollar would be good for global economic growth as investment dollars flow out of the US and into emerging markets, for example. A falling dollar would also make it easier for emerging-market entities to service a huge amount of dollar-denominated debt that has been issued over the past several years.
- Another reason for the weaker dollar is that the US has seen a big spike in COVID-19 cases even as many other countries appear to be out of the woods. The sudden flair up at home has many worried that the US economy will be slower to recover from the pandemic. Recent data out of Europe suggests that the second largest economy in the world may be gaining steam. The decision by the EU to issue bonds backed by all the eurozone’s 19 countries for the first time may further increase the optimism about Europe’s economy. As domestic prospects have dropped and foreign economies have firmed, money has flowed out of US dollars.
- As interest rates in the US continue to fall, the rate differential between the US and other major countries has compressed significantly. This compression reduces the profitability of the carry trade.
- The deteriorating COVID-19 situation has increased political uncertainty. Prior to the outbreak, President Trump had seemed a shoe-in for another term and continued market-friendly policies (tax cuts, deregulation, heavy government spending). Now, however, most believe that Biden will be the favorite to win in November. The stock market doesn’t seem too worried about this possibility, but the bond market might be showing some signs of nervousness. And perhaps the worst-case scenario, a drawn-out contested election, cannot be ruled out either. In any case, the increased uncertainty may be responsible for some of the dollar’s recent drop.
- Many economists now believe that the US budget deficit could approach $4 trillion for this year. Federal debt outstanding (including borrowings from the Social Security trusts) is starting to get very high, with the possibility of approaching $30 trillion within the next couple of years. Are Treasury bond investors getting incrementally more worried about the US government’s financial standing? If so, that could be affecting demand for dollars. However, given that the 10-year Treasury bond is yielding only about 0.55% right now, appetite for US debt still seems pretty insatiable.
The reversal in the dollar is hardly alarming at this point. Still, many economists believe the weakness will continue given all the uncertainty discussed above. As it relates to investing, the recent dollar weakness offers a welcome respite for US multinational companies that have suffered from dollar strength for years. Roughly 40% of S&P 500 revenues are derived outside the US, and so now may be a good time to identify those companies most likely to benefit from the trend. Many of these companies have underperformed dramatically over the years as investors have sought a US-centric approach. If we are indeed seeing the beginnings of a rotation, the bull market may have legs.