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A third US dollar bull market getting underway

28th September 2014



A muscular US dollar has been one of the movers and shakers in global finance markets in recent weeks. It’s always risky to extrapolate momentum unless you have a strong feel for trading and positioning, but this aside, it looks as though the third US dollar uptrend of the post-Bretton Woods era may be underway, following a few false dawns over the last couple of years, including at the start of this year when it surged momentarily against a number of emerging market currencies. If it remotely reflects its two previous predecessors, we should brace for some interesting implications for the global economy, markets, and importantly, emerging countries.


I make no reference here to geopolitical developments in Eastern Europe, the Middle East and the South and East China Seas – or recent developments in Hong Kong – as factors influencing the US dollar’s attraction or otherwise. Normally, gold would be a  beneficiary of geopolitical tensions, but it’s also possible that investors will buy US dollars as they bale out of positions in currencies directly related or close to areas of stress.


The trade-weighted value of the dollar, labelled in markets as DXY, has risen by 8% since the last low of 79.2 in early May. Standing at 85.6, it could now break decisively out of a range of 79-85 in which it has traded since falling away from 88.3 reached in the economic bounce in 2010. The US dollar has been pretty feisty against the Japanese yen for a while, but the latest rise to over Yen 109 has been tame against the 6% or so rise against the Euro. For much of the last 2 years, the US dollar has fluctuated in band of around EUR 1.25-1.40, but the stronger US dollar now threatens to breach the 1.25 level, aide and abetted by the European Central Bank.


As the dollar rises, most likely supported by some rise in US nominal and probably real interest rates, the investment environment is going to change. To a degree, it’s already started with new weaknesses in some emerging markets and industrial commodity prices, both of which prospered as the US dollar declined from 2001 until relatively recently. Be warned: the two previous US dollar bull markets were associated with profound shocks. The 1978-1985 uptrend brought down Latin America, the 1992-2001 version brought down Asia. It’s quite likely that EM will be in the crosshairs this time too.


Before that though, let’s go through

  1. a bit of background to put the US dollar’s post-Bretton Woods cycles into some context;
  2. why the US economy has to perform reasonably well to support a stronger US dollar; and
  3. the downside line of least resistance for the Euro and the Yen.


Feast and famine cycles since the early 1970s


Since the collapse of Bretton Woods, the US dollar has completed three down cycles (famines) and two up cycles (feasts), with an average length of a little over 7 years.


Down 1968-1978. The longest bear market was the initial Bretton Woods collapse, the first major warning signs coming with the gold market crisis of 1968. But this was just a sign of fundamental problems related to the decline in America’s share of world output as Japan and Germany took their places in the global system, later to the economic consequences of the US ‘guns and butter programmes’ , i.e. financing of the Vietnam War and Great Society social programmes), and then to the war and oil price crises in the Middle East.


Up 1978-1985. The subsequent bull market occurred on the watch of then Fed Chairman, Paul Volcker, who’s principal task was to reverse the rise in US inflation, which reached nearly 15% in 1979. Vigorous monetary tightening exposed the frailties in the balance sheets of of US banks and, especially, of savings and loan institutions, and created an impossible environment for many countries in Latin America that had borrowed extensively in US dollars at much lower interest rates to finance adjustment to the oil price shocks. The Mexican default in 1982 kicked off a decade of debt crises through the region.


Down 1985-1992. The second bear market was instigated by the Plaza Accord between G5 nations in 1985, and designed to lower the US dollar against the Yen, D-Mark and so on, against which it appreciated by around 50% since 1980.


Up 1992-2001. The second bull market, the longer of the two, followed and occurred against the backdrop of America’s longest peacetime economic expansion, significant productivity gains from the new boom in information and communications technology, important welfare reforms, and the transformation of fiscal deficits into four years of budget surpluses by the end of the period.


Down 2001-2008. The third bear market kicked off with the top of the technology boom and ended seven years later as the Great Financial Crisis started to erupt in April 2008. During this period, the seeds of the financial crisis were sewn, and the external (current account) deficit doubled from around 3% at the turn of the decade to 6%, or around $800 billion, in 2006. At the end of the period, the crisis drove the US dollar index DXY down to a record low of 71.5.


The downwave was underpinned by important shifts in asset allocation post 9/11 in the wake of numerous factors, including very easy US monetary conditions, the search for yield in emerging markets, the financialisation of commodity markets, the evolving Euro-system, and China’s turbo-charged growth rate and global ascendancy. More activist central bank reserve management ended up with the US dollar component of their reserves falling by about 10% to 61%. And sovereign wealth funds with assets now over $5 trillion diversified too, though this is impossible to verify in what remains a highly secretive space.


Up 2008 -? 


Since the all time low in April 2008, you could argue that a weak and erratic bull market is already six years old, and almost over. But the last 5-6 years have been essentially trendless with DXY fluctuating in a range, mostly, of 74-84. It looks like it can keep going.


It isn’t that the US economy is on fire, despite the 4.6% annualised growth in GDP in Q2 2014, following very weak performance at the end of 2013 and the start of this year. And it certainly hasn’t resolved important structural shortcomings in labour markets, income formation, income inequality, the tax code, private investment, and longer-term fiscal accounts. But relatively speaking, it’s doing a lot better than both Japan and Europe.


It has been able to put blue water between the financial and banking crisis and its own economic prospects. Banks are intermediating credit again, at least to commercial and industrial companies. Nominal GDP growth has recovered to grow at an underlying pace of around 4%. The risk of deflation is certainly a lot lower than in Europe and Japan. The housing sector is off the floor, and capital spending by companies and non farm payroll jobs are rising. The underlying economy has improved enough for the Federal Reserve to bring QE to an end in October, and markets are trying to decipher when the Fed will raise policy rates over the next year or so, and how far the process might go. As these events draw nearer, we should expect still low US bond yields to adjust to reflect such expectations and benefit the US dollar. Always provided, of course, the US economy, itself, doesn’t have a relapse or sink back into a recession – at least any time soon.


The nightmare scenarios that were circulating about the US fiscal deficit time bomb until about 2013, propagated not least by those with only a political agenda, have proven to be just that. The budget deficit has contracted steadily from almost 10% of GDP in 2009 to an estimated 2.8% of GDP this year (according to the Congressional Budget Office), even though it is predicted to widen again over the next 10 years as Medicare costs under current law, start to pressure the government. But for now, the deficit is simply not an issue.


The US external deficit has shrunk to about 2.3% of GDP. It may not shrink much more bearing in mind that stronger relatively stronger US demand will be reflected in higher imports vis-a-vis its main trading partners, but it may not grow that much either when you think about the on-going move towards lower energy import dependence, and the US lead in new energy and other technologies. The International Energy Agency expects the US to produce more oil than Saudi Arabia by 2017, while the US technological lead in advanced manufacturing is an enduring asset, as cost structures decline, sharpening the country’s competitive edge and providing incentives to create output and jobs at home.


ECB reliance will push the Euro lower 


It’s hard to say how far the US dollar might rise against the Euro, but I reckon it could get to around 1.15-1.20, perhaps higher. Much depends on the behaviour and operations of the ECB, which has certainly helped to create an environment conducive to a weaker Euro. For example, it has already announced further reductions in its benchmark rate to 0.15%, a 0.1% charge on deposits that it holds for banks, a new lending facility (TLTROs or targeted long term repurchase operations), and this week, it will unveil details of its plan to buy asset-backed securities.


But if the name of the game is to deliver Europe from deflation and economic stagnation, these measures don’t cut the mustard. The cost of borrowing in Europe has already declined significantly. To the extent that the private sector and SME’s may not have benefited as much as sovereigns, the ECB’s current tool-kit may not have much effect. And it won’t unless the forthcoming Asset Quality Review and third stress test lead directly to an early and significant increase in bank capital that is no reliant on shrinking loans and investments further.


The last chance saloon for the ECB, which the FX markets and others continue to expect, is full-fledged QE via sovereign bond purchases. But even this is not assured. Buying German and core country bonds won’t lower yields meaningfully, while buying peripheral sovereign debt out of line with GDP weights or some other formula isn’t permitted. In any event, we have to await the European Court of Justice’s ruling on OMTs – timing unknown – referred to it by the German Constitutional Court. The ECJ can hardly be expected to rule that OMTs are incompatible with primary law, but the fine print may impose important limitations on what the ECB might be able to do when it comes to QE.


QE or not, it’s hard to see the ECB delivering the Eurozone from economic stagnation on its own – since this is a task that now requires broad-based national and EU-level policies that address debt relief and public investment. Absent these, we should expect the Euro to continue to decline, reflecting a poor economic backdrop, and the consequences of relying solely on the ECB to ‘fix’ Europe.


By contrast, a weaker Japanese Yen has been a specific objective of Abenomics, and of the Bank of Japan’s QE in particular. Growth faltered badly in Q2 after the rise in the consumption tax, and even though Abenomics still promises structural reforms, the outlook for sustaining the blip up in inflation is poor. Similarly, there is little of substance to indicate that Japan’s structural shortcomings when it comes to labour markets, income formation, immigration, corporate governance and product and corporate competitiveness are being addressed. The yen has already fallen a lot, and it is likely to depreciate further over the next year or so.



Emerging markets…not again?


The eruption of the Asian crisis in 1997-98 during the second US dollar bull market of 1992-2001 has been the subject of much debate. There’s no question that Asia experienced a massive competitiveness shock and chronic financial instability. Some have argued that China’s 35% devaluation in 1994 was a trigger but this change only applied to the then official rate, used to convert little more than a fifth of export receipts, not the floating or swap-market rate that was determined largely in the market. Others have pointed to the bursting of the Japanese asset bubble in 1990 and Japan’s subsequent decline but there is no evidence that Japanese imports from Asia were in a slump before the Asian crisis.


The biggest shock to Asia, though, was the 50% depreciation of the Japanese Yen against the US dollar, from JPY81 to JPY135 between 1995-1997, and it didn’t touch bottom until April 1998 when it reached JPY147. Asian economies mistakenly tried to keep their exchange rates firm against the soaring US dollar, resulting in massive appreciation against the Yen, but also against the D-Mark and other European currencies.


This time, as the US dollar strengthens, the old exchange rate policy dogmas are long gone. Asia, and emerging markets in other regions, have shown tolerance, allowing their exchange rates to drop against the US currency – though not always without some monetary restraint to brake the decline in their own currencies.


Other things have changed. Developing Asian countries’ trade with one another now accounts for around 45% of total trade, compared with 30% in 1990. China now imports between a fifth and a quarter of developing Asian foreign shipments (excluding Hong Kong and India), compared with 10% or less before the Asian crisis. And there are no notable cases of strong currency over-valuation. In general, emerging countries have high levels of international reserves, and relatively little external debt compared to the 1990s. Many of them have refinanced a lot of their US dollar debt in to local currencies. With one or two exceptions, for example, India, they tend to have relatively small fiscal deficits and public debt ratios.


On the other hand, it is complacent if we imagine that the capital flows that have poured into emerging market real estate, local currency bond and equity markets will be immune to an appreciating US dollar and some rise in US interest rates.


Carry trades, the borrowing of cheap US dollars to finance the buying of EM assets with high returns, are already being unwound. But a higher US dollar, higher US borrowing costs, and deteriorating EM asset returns mean there’s most likely a long way to go. Liquidity will be sucked out of the global system, precisely the opposite of what happened when the US dollar bear market was in full flow. EM currencies in the aggregate have already declined about 6-7% against the US dollar this year, and more should be expected.


Global trade and demand aren’t going to rescue EM, for many of which selling goods to Western consumers is the leitmotif of their economic models. The 2:1 typical relationship of world trade to world GDP growth has broken down, the two series rising modestly in tandem.


China’s economic growth is sliding, for structural and political reasons, and the government’s main task is to ensure that it can manage a growth and economic transition with a minimum of disruption. Fixed asset investment is still growing at a nominal 15%, but this is half of what was normal a couple of years ago – and it isn’t just property that’s in the firing line, but infrastructure and manufacturing as well. A broad array of countries exporting to China is going to feel the chillier winds of China’s more sobre economic environment.


However economic rebalancing happens in China, the commodity intensity of China’s growth is sure to decline, not least because the commodity import multiplier for consumption is lower than it is for investment. The shift in GDP shares from investment to consumption, therefore, will spread weakness to industrial and energy exporters to China. It will also impact those countries most integrated into China’s supply chains. The IMF has estimated that for every 1% fall in Chinese investment growth, the biggest negative growth effects are on Taiwan, Malaysia, and S. Korea. Nevertheless, give the reorientation of most countries’ trade patterns towards China, it is highly likely that a slowing China will have ripple effects throughout the emerging world. The biggest effects among commodity exporters are likely to be on Chile, Zambia, Saudi Arabia, Kazakhstan and Iran (and Perth, presumably).


China, of course, isn’t the only country in the EM world that’s facing a challenging transition in the wake of a) much less benign global circumstances for economic catching up than prevailed over the last 20 years, and b) the end of extrapolation, or, in other words, the end of the growth surge that happens during economic catching-up. For many richer EM, the challenge to sustain anything but pedestrian economic growth is, no less than in the West, structural economic and political reforms, designed to raise productivity again. China aside, the need for reforms has become urgent not only in the so-called Fragile Five – Brazil, India, Indonesia, Turkey and S. Africa – but also in countries such as Malaysia, Thailand, Chile and Mexico.


Credit expansion has been the backstop in many countries, such as China, Brazil, and Turkey substituting poorly for the difficulties of implementing political and economic reform. In Asia, non-financial corporate debt has risen strongly, driving total non-financial debt to GDP ratios up to match the US, moving in a downward direction, and rivaling the lofty levels reached in the EU. High or excess capacity, the erosion of pricing power, and high debt levels make for a worrisome backdrop to a forthcoming rise in US interest rates and the US dollar.