In this two-part essay, we look at the implications of the current crisis on the triumvirate of forces which we feel will drive economies and markets in the months and years ahead. This week, we examine how our expectation of an initial deflation followed by growing inflationary pressures will impact currency markets. .
“We are witnessing the Great Monetary Inflation – an unprecedented expansion of every form of money unlike anything the developed world has ever seen.”
– Paul Tudor Jones II, Founder and CIO, Tudor Investment Corporation, May 2020
“Most people don’t pay enough attention to their currency risks. Most worry about whether their assets are going up or down in value; they rarely worry about whether their currency is going up or down.”
– Ray Dalio, Co-CIO and Co-Chairman, Bridgewater Associates, May 2020
Last week we explored the deflationary and inflationary forces unleashed by the COVID-19 crisis. We concluded that the initial impact of these forces was likely to be profoundly deflationary, due to a combination of a severe demand shock, exacerbated by staggeringly high levels of debt which will accrue to fund the crisis response. This debt will ultimately force governments and compliant central banks down a path of debt monetization that will lead to increasing inflationary pressure.
Currencies and Deflation
These two distinct phases, deflation followed by inflation, will likely be the primary factors driving currency market direction and volatility in the years ahead. Understanding the unique role of the US dollar, as the global reserve currency and the primary international funding currency, is fundamental to any analysis of how currency markets are likely to react to what we expect will be a very different macro environment to what we have experienced in the decade since the Global Financial Crisis. We expect the US dollar to outperform most of its peers in the forthcoming deflationary phase. However, the prognosis for the currency in any future inflationary episode is much less clear.
Deflation should strengthen a currency and inflation should weaken it. After all, deflation is just the process of a currency becoming more valuable in terms of purchasing power. Like most financial market ‘rules’ however, there are (frequent) exceptions – for example, when interest rate differentials (carry) are driving currency markets, this relationship can break down as deflation is seen as a precursor to cutting rates (I explored this theme back in 2013 here).
This relationship is not particularly helpful to us now, however. If our expectations are correct, most advanced economies will experience deflation over the next two to three years. It is not relative country-specific inflation rates that will matter, but rather how currencies perform in a general deflationary environment.
The US dollar should benefit from deflation
The US dollar’s unique role in global finance is the key to why we feel that the currency will outperform during the coming deflation. There are three inter-related functions of the dollar that underpin this conviction:
1. Role as the global funding currency
Almost 40% of the world’s debt is issued in US dollars, and over $12 trillion of this is issued to non-financial borrowers outside the US (this is over triple the amount of foreign debt issued in euros, the next largest player in international capital markets). Banks in countries like Germany, France and the UK hold more liabilities in US dollars than they do in their domestic currencies.
In a deflationary environment, the creditor benefits as the value of the debt increases in real terms. In practice, this US dollar debt sitting outside the US represents a massive short position on the dollar. In a deflationary environment, this short position will get squeezed as debtors seek to buy dollars to service this debt.
We have already seen the effects of this demand manifest as stress in the FX swaps market, where demand for dollars increased the EURUSD cross currency basis (the difference between the theoretical and actual forward rates) by over 100 basis points before the Fed extended 14 swap lines to provide billions of dollars to temporarily satiate this international demand. These swap lines are only addressing the symptom (liquidity) and not the disease (the underlying short dollar position) and the 12 trillion of foreign debt denominated in US dollars represents a persistent source of demand for dollars in a deflationary environment.
2. Reserve currency status
The US dollar’s position as the global reserve currency will benefit it in two main ways. First of all, the US dollar (and US financial markets) will benefit from the safe haven appeal that accrues to the world’s most liquid currency. When investors are scared (and a deflationary environment is scary) they go to cash, and cash (for most) means the US dollar. A frivolous illustration of the dollar’s popularity is that of all the physical dollars in circulation – about $1.7 trillion – over half are estimated to sit outside the US!
A less direct way that the dollar’s reserve currency status will support it in a deflationary environment relates to the current account. The US runs a large current account deficit in part enabled by the dollar’s role as a reserve currency. A deflationary environment implies weaker global trade. This will reduce US dollar selling by foreign exporters (or US importers) and should strengthen the dollar relative to currencies of current account surplus regions (Europe, Japan).
3. Unit of account for the international commodity trade
Most internationally traded commodities are priced in US dollars. In a deflationary environment, commodity prices will be expected to decline in price and there is a well-established negative correlation between the US dollar and commodity prices.
This would seem to further confirm our hypothesis that deflation will lead to a strong dollar. But wait a minute…correlation does not imply causation! If the dollar itself is the driver of the relationship (i.e. if a strong dollar just means that international commodity prices ‘adjust’ to the strength – or weakness – of the dollar) then this argument falls over.
However, the evidence suggests otherwise. A 2016 paper by the Bank for International Settlement concluded that commodity prices are a leading indicator for exchange rates. They even specify the causal link: that higher (lower) commodity prices lead to an increased (decreased) supply of foreign exchange (i.e. US dollars) in the economies of commodity exporters, leading to an appreciation (depreciation) of the local currency.
This effect is likely compounded by an increasing (decreasing) flow of capital into these economies as a result of more (less) attractive investment opportunities in the long term. In other words, lower commodity prices (deflation) should strengthen the US dollar, especially against commodity exporting currencies.
A transition to an inflationary regime will weaken the US dollar’s structural advantages
OK, so we have established why we feel that the US dollar should benefit from the deflation to come. But, what about further down the road, when inflation begins to kick in? As we indicated last week, we feel that this inflationary risk will grow as the politicization of monetary policy increases.
As legendary hedge fund manager Paul Tudor Jones II predicted in his market outlook last week: ‘the risk of a complicit (politically-appointed) central bank chairman cannot be easily dismissed given that central bank independence is no longer a sacred cow.’ (emphasis added).
First of all, it is important to emphasize that our forecasting convictions generally become weaker the further into the future we look. As such, the impact on the US dollar of an inflationary period beginning two or three years from now is necessarily a much more complex prediction to make. Secondly, we would expect currency markets to behave in a more idiosyncratic way in any future inflationary period (all currencies would be damaged, but some (much) more than others.
With these two caveats out of the way, we will make a few predictions: ·The US dollar’s ‘safe haven’ appeal will be damaged as the credibility of the Fed is weakened. ·Should the euro survive in its current form (or close to it) its unique structure will reduce the risk of politicization. European debt monetisation would have winners (Italy) and losers (Germany) that may reduce the scale of such currency debasement. Ironically, the euro could become the new ‘safe haven’! ·The US dollar’s current premium (it is currently overvalued against most of its peers by at least 10-20%) would become less sustainable as its safe haven appeal weakens, creating substantial downside risks.
The US dollar will have a ‘Minsky Moment’ – but this is likely years away
Economist Hyman Minsky wrote ‘stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.’
The financial instability triggered by the COVID-19 crisis, and the extraordinary expansion of global debt that is underway, points toward an extended period of deflation in which the US dollar should continue to outperform, offering (relative) stability for international investors. However, the dollar’s stability is, and will continue to be, closely linked to the credibility of the Fed, and to its unique role as the global reserve currency. If, as we expect, we experience a future phase transition into an inflationary environment, this will reduce the comparative advantage that the dollar currently holds over its peers, increasing the risk of US dollar depreciation in the longer term.
Author: Kevin Lester