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Much of the sentiment around the recent path of the US dollar has been justifiably bullish. Sweeping corporate tax cuts, the US Federal Reserve’s diverging monetary policy against the rest of the developed world and positive economic fundamentals helped power its rise in 2018.
Lurking beneath, though, are cyclical shortcomings that could start to drag on the greenback and threaten its reliability as a haven in the next global downturn. If this happens, options such as the Japanese yen could offer as good as, or better, portfolio protection.
While structural concern over the dollar has existed for decades, what is different is that major levers that drive supply and demand for US government bonds are increasingly negative for the dollar.
The publicly held US federal debt load is expected to balloon to 100 per cent of gross domestic product by 2030 from 78 per cent in June 2018, according to the Congressional Budget Office.
Historically, investors have brushed aside rising US debt because of high overseas demand for Treasuries, dominated by China’s appetite to build foreign exchange reserves to help stabilise its currency and economy. Reserves, however, are no longer in their growth stage: a major source of funding for US Treasuries is drying up.
In the short to medium term, the incentives for foreign reserve funds to increase dollar exposure are further diminished as the US tries to reduce trade deficits, for example by imposing higher tariffs, particularly with China. President Donald Trump’s efforts to tip foreign trade policies in his favour may inadvertently undermine the dynamics needed to sustain his fiscal policies.
The structural weaknesses for the dollar are coupled with cyclical challenges. The dollar’s performance has not been as consistent as investors think, given the tailwinds in its favour. In the first quarter of 2018, for example, the dollar spot rate as measured by the US Dollar Index (DXY) weakened by as much as 4.25 per cent.
That trend proved shortlived but the dollar may soften again this year. US growth appears robust but the liquidity cycle is turning. The Fed is more advanced than other central banks in reversing the unconventional monetary policies of the post-financial crisis era.
A combination of increased volatility and a depreciation would put pressure on the dollar’s haven status. This scenario could transpire if US growth versus the rest of the world looks to be increasingly challenged, the Fed makes a policy mis-step or volatility rises for US assets — government bonds in particular.
The yen, for example, may provide the same or better safety characteristics than the dollar.
This paves the way for other currencies. The yen, for example, may provide the same or better safety characteristics than the dollar.
There are three reasons. First, Japanese investors have high exposures to foreign assets, especially US assets, and are likely to repatriate those if volatility rises in global markets, supporting the yen.
Second, while the Bank of Japan has not reversed quantitative easing, it has signalled monetary tightening and this could lift the yen. The BoJ has also trimmed its bond purchasing programme, which was 40tn yen in 2018 compared with twice that amount two years previously.
Third, the yen is about 10 per cent undervalued and the US dollar 10 per cent overvalued as at January 11, based on a standard fair valuation model using deviations from historical real effective exchange rate averages. While currencies tend to revert to historical means in the long term, it is difficult to time inflection points. Nevertheless, the yen’s defensive characteristics are stronger. In December, the yen rose 3.5 per cent against the dollar in a period in which the S&P 500 had one of its worst monthly declines in years, retreating by about a tenth.
American exceptionalism has drawn huge amounts of foreign capital to its shores but market dynamics are changing. Now is the time for investors to reconsider risk-reducing strategies and specifically the yen’s role within it.
This article first appeared in the Financial Times