With US real interest rates sinking ever more deeply into negative territory as the Fed signals it is on hold for a prolonged period, the outlook for the dollar is bearish for the first time in a decade, argues Mark Robertson.
A quick search on Google reveals no shortage of firms advertising foreign exchange trading as a means of getting rich quickly. No doubt some talented or lucky individuals have made themselves a fortune. But while not professing to be an expert in the field of day trading, I know enough to say that for every winner there is probably no shortage of losers. As such, what some of these apparent gurus and soothsayers have to say about the industry should be taken with a grain of salt.
You don’t have to be a devotee of the efficient market hypothesis to know that making money out of trading any financial asset is not straightforward. If it were, the world would be full of multimillionaires and right now I’d probably be indulging my wanderlust, rather than writing this note.
If getting more of your bets right than wrong when investing in traditional assets classes is far from easy, it’s significantly harder still when it comes to making money out of currencies. For a start, they are not like bonds, which over time tend to deliver positive returns thanks to their coupons, or equities which, in addition to dividends, offer growth potential.
The fickle nature of currencies
Trading currencies is a zero-sum game. For everyone who makes money out of going ‘long’ one currency against another, there is someone incurring an equivalent loss by holding the opposite position.
Currency markets can be fickle in terms of which catalysts they choose to focus on
Moreover, not only is there a wider collection of potential drivers of returns to consider, markets can be fickle in terms of which of those catalysts they choose to focus on. Just when it appears a widening current account deficit is likely to push a currency lower, the market flips and focuses instead on interest rate differentials that are in its favour.
Figure 1 highlights what I mean. It plots the euro’s value against the US dollar since the single currency’s inception at the start of 1999. In the first 22 months of its life, the euro was friendless. Having initially been worth 1.18 dollars, by the following October it had lost 30 per cent of its value, hitting a nadir of 0.827 dollars towards the end of that month.
But it then rebounded equally rapidly. Over the next seven and a half years, the euro virtually doubled in value, peaking in April 2008 at just above 1.60 dollars. The rollercoaster ride wasn’t finished there. The euro then gave up most of those gains in the subsequent decade as it tumbled back towards parity.
While it would be an exaggeration to suggest the world’s most actively traded exchange rate has been on a random walk for the past two decades, it does illustrate the difficulty in determining the likely path ahead. During the whole of this period, the US was running big trade deficits, while interest rate differentials were generally in the dollar’s favour.
Figure 1: Euro's rollercoaster ride
Re-evaluating our position
Given this inherent unpredictability, it may seem strange that one of the biggest changes we have made to our multi-strategy portfolios over the course of this year has involved our currency positioning. At the start of 2020, we were long the dollar against a basket of Asian currencies in the belief Donald Trump’s trade war with Beijing would hurt the renminbi and with it the exchange rates of a number of other countries in the region that depend heavily on China for trade.
Interest rates had much more room to fall in the US than most other developed market countries
But when it started to become clear early in the new year the COVID-19 pandemic would have grave implications for the world economy, and in turn financial markets, we began to reappraise this position. After all, interest rates had much more room to fall in the US than most other developed market countries.
Given memories of the global financial crisis, it was not totally unexpected when the dollar initially spiked sharply higher. By 20 March, it had gained 6.9 per cent against the euro in the space of just nine trading sessions. The greenback made similar advances against almost every other currency as companies and banks rushed to get hold of it to pay creditors, trade partners and suppliers and to roll over dollar funding.
Yet the rally proved short lived as the US Federal Reserve (Fed) slashed interest rates, injected trillions of dollars into the financial system and opened swap lines to an expanded total of 14 central banks. The aim of this latter move was to ease dollar strains by reducing the need for foreign banks and corporations to access funds directly via the market.
Then, at the end of August, the Fed went one step further and relaxed its inflation objective to try to help steer the US economy out of recession. The central bank said it will tolerate inflation “moderately above two per cent for some time” after periods of persistently low inflation.1 Chairman Jerome Powell called this strategy “a flexible form of average inflation targeting”.2 While this was not unexpected, the announcement sent a signal to the market that the Fed is going to be very slow to raise rates when the recovery takes hold.
Bond markets have begun to price in the threat of higher US inflation
Although financial markets remain sceptical the Fed will be able to engineer significantly higher levels of inflation in the near term, with US rates expected to stay near zero for an extended period, possibly years, bond markets have begun to price in the threat of higher US inflation looking further ahead. A large part of this is down to the expectation fiscal policy will provide a much greater boost to the economy than we saw after the financial crisis.
For instance, ten-year ‘break-evens’ – the yield differential between government bonds that protect against inflation and those that do not – have climbed steadily since hitting a multi-year low in March. By this yardstick, inflation is expected to average 1.7 per cent over the next decade, up from just 0.5 per cent in the spring.
Collapse in real yields undermines the dollar
With the Fed keen to prevent nominal bond yields from rising, this has led to US real yields collapsing. At the same time, German real yields have risen amid doubts the ECB will be able to thwart deflation in the euro area. As a result, whereas in September ten-year inflation-linked US government debt was offering a real yield 185 basis points higher than that on comparable German government bonds, real US yields are now 54 basis points lower, as Figure 2 shows.
Figure 2: US's 10-year real yield sinks below Germany's
Although the euro has rebounded 11 per cent from the low point reached at the height of the crisis, the rally looks to have further to go given this major shift in relative real interest rates. This explains why our portfolios, having been long the dollar at the start of the year, are now short; mainly versus the euro.
Interest rate differentials have been the key driver of the dollar for some time
While different factors can influence currencies over time, interest rate differentials have for some time been the key driver of the dollar. As Figure 3 shows, it has been appreciating against a broad basket of currencies on a trade-weighted basis ever since the financial crisis. Apart from China, economic growth in the US has outstripped that of the country’s biggest trading partners. This allowed the Fed to tighten monetary policy more than elsewhere.
The combination of stronger economic growth and higher interest rates encouraged foreign capital to flow into US assets at a faster rate than was required to plug the US’s ever-expanding trade deficit. For instance, with government bonds yielding zero or less in the likes of Germany and Japan, US Treasuries offering appreciably higher yields looked relatively attractive. And, with the US economy outperforming most others, US equities also proved alluring.
Figure 3: Trade-weighted dollar index: Broad, goods and services (re-based)
Ordinarily, foreign buyers of US assets might have been expected to hedge the bulk of their resulting currency exposure. After all, in recent years fluctuations in the dollar were one of the biggest risks to a foreign investor in US Treasuries. But with US rates appreciably higher than elsewhere, all too often the cost of hedging was deemed prohibitive. In many cases, investors opted to hedge just a fraction of their currency exposure or none at all.
Hedging gets cheaper
However, with nominal US interest rates now close to zero, and real rates more negative than elsewhere, the cost of hedging dollar exposure has plunged. We are already seeing signs global investors’ behaviour is changing. As they roll over positions, as and when existing hedges expire, we believe more and more investors will opt to fully hedge their exposure.
At the same time, negative real US interest rates diminishes the relative appeal of US bonds and other US assets. As an example, while it may be dangerous to bet against the US economy continuing to outperform most others, US equities suddenly have a steeper hill to climb if they are to go on outperforming.
Global investors have bought so many US assets in recent years we are not convinced many will want to own significantly more
While a weaker dollar could in some circumstances be seen as positive for US asset prices, global investors have bought so many US assets in recent years we are not convinced many will want to own significantly more.
Against this backdrop of potentially reduced foreign demand for US assets and foreign investors’ increased willingness to hedge any exposure to the dollar, the path of least resistance appears to be for a weaker dollar as the US looks to fund its record trade deficit.
There is little doubt foreign exchange trading is complex and can be risky. But it can also be hugely profitable if you can detect a shift in the long-term trend early enough. This shift in relative real interest rates looks as if it could be one such moment.
Even if there are inevitable doubts over its ability to generate inflation, with the Fed now indicating it is prepared to do whatever it takes to bring about such an outcome, the dollar may be heading for troubled times.
