Nearly a century ago, economist Irving Fisher observed that the business cycle is largely a “dance of the dollar.” This remains as true today.
Even though America’s share of world output has shrunk over the years (from an all-time high of almost 40 percent after the Second World War to less than 20 percent in 2020), the dollar still represents 88 percent of global FX transaction volumes, 80 percent of global trade settlement, 63 percent of global FX reserves, 62 percent of global debt issuance, and 50 percent of all cross-border bank claims. This is why we often refer to the dollar as the single most important macro variable.
The dollar has experienced three bull and bear cycles in the past 50 years. Each historical dance begins with innumerable forces acting upon each other.
From 1971 onwards, the dollar was in a bear cycle as America went off the gold standard, sparking fears about currency debasement. The 1973-74 oil crisis fueled inflation and the real federal funds rate was negative for most of the period.
Starting in 1981, a four-year bull cycle followed. The US was in recession and oil prices crashed because of a supply glut. America benefitted from a substantial terms-of-trade improvement, meanwhile a sharp decline in inflation helped sustain an environment of high real interest rates. Many Latin American countries were unable to service their foreign debt.
The second bear cycle kicked off with the Plaza Accord in 1985, when the G-5 nations (the US, the UK, France, Germany, and Japan) intervened to weaken the dollar.
From 1995 onwards, a number of dollar-supportive dynamics produced a second bull cycle. America’s growth was robust, and its capital markets attracted substantial inflows from abroad. The dollar also benefitted from some risk aversion flows throughout the period, ranging from the Asian crisis (1997), the Russian default (1998) and tension in Brazil (1999). The dollar rallied through the dot-come bust and the 2001 recession.
The dollar entered its third bear cycle in 2002. America faced record twin deficits and prolonged monetary easing. Meanwhile, the euro was officially adopted across twelve countries in the Eurozone and China’s entry on the world stage transformed the outlook for emerging economies. The dollar became a funding currency for higher-yielding investment.
By 2011, the dollar had fallen 52 percent from its major peak in 1985. S&P downgraded America’s credit rating, which coincided with the beginning of the third bull cycle amid deflationary conditions and waves of uncertainty around the world. We can breakdown this phase into three distinct stages.
The first stage of the dollar bull run simply corrected negative sentiment and historic undervaluation. The dollar index rose 15 percent.
In mid-2014, interest rate differentials and growth trajectories favored the US over other countries. This resulted in the largest annual dollar rally in thirty years. The dollar index rose from 79.8 to 103.6, a gain of 30 percent. This was the second stage.
Since 2018, we have been in the third and final stage. The dollar index has so far risen 10 percent amid an escalating trade war with China. But the combination of growing trade protectionism and the demand shock from Covid-19 has the potential to send the currency significantly higher than anyone imagines.
The coronavirus pandemic has changed the world in profound ways, but in one area of international finance, turbulent forces have only cemented the status quo. The dollar is still the ultimate safe haven currency. America is still best positioned to withstand currency strength.
At a minimum, we expect the dollar index to hit 110 by the end of next year, good for another 10 percent rally from current levels. That would complete an advancing 5-wave Elliott Wave pattern, marking the end of the dollar bull cycle. This is the last dance.
If we are correct in our thinking, the euro will fall below parity against the dollar. The pandemic is reopening the political fissures across Europe, with tensions between hardest-hit southern nations and the financially stronger north.
Emmanuel Macron has warned of the collapse of the EU as a “political project” unless it supports stricken economies such as Italy and helps drive its post-virus recovery. “If we can’t do this today, the populists will win—today, tomorrow, the day after, in Italy, in Spain, perhaps in France and elsewhere,” Macron said. The EU faces a “moment of truth” in deciding whether it is more than just a single economic market.
France is pushing for the creation of a joint fund or EU budget allocation of about €400 billion in addition to emergency assistance already offered by the ECB and other EU institutions to mitigate the deep economic slump from coronavirus-related lockdowns across the bloc.
Eurozone finance ministers so far haven’t agreed on sharing the burden of extra public debt. As it stands, only nine members of the euro area want to break with convention by issuing joint eurozone debt or so-called “corona bonds.” Germany and allies such as the Netherlands, Austria and Finland have resisted a push led by the French, Italians, Spaniards and Portuguese.
“In Europe, things take a bit more time than we would like, but we always find a solution,” ECB president Christine Lagarde told Le Parisien. The great virtue of the repeated existential crises faced by EU leaders is that they have ultimately made the political reversals, economic sacrifices, and legal maneuvers necessary to hold the continent together. Each crisis has reinforced integration over disintegration.
A decade marked by recessions, sovereign debt crises, and political turmoil has led to policy flexibility that was deemed inconceivable each time—from frequent infringement of the 1992 Maastricht Treaty rules that government deficits should not exceed 3 percent of GDP and government debt should stay below 60 percent, to the ECB’s quantitative easing programs, negative interest rate policy, corporate bond purchases, and decision to temporarily buy Greek debt and accept bonds downgraded to junk as collateral from banks.
In an unprecedented decision, the European Commission is suspending its strict rules on public deficits, giving countries free rein to spend whatever is needed to fight the pandemic. The ECB has ditched limits to the amount of a country’s bonds it can buy under its new programme and also considering controversial purchases of junk debt as part of its toolbox.
Lagarde has promised that the ECB “will do everything necessary” to tackle the biggest economic contraction unprecedented in peacetime. She insisted there are “no limits to our commitment to the euro.”
Judging by history, markets will “test” that commitment once again. We suspect that happens with a decline in the euro below parity against the dollar—a level it has trade above since December 2002. Commitment of Traders data shows the spread between Large Specs and Commercials is at previous extremes coincident with a top in the euro. We expect the decline will resume from below 1.12.
There is more complacency among EU leaders today than ten years ago, reflected in the slowness in action and the rancorous debate about corona bonds. The continent can come out stronger from this crisis, but the euro must fall sharply first to create the “panic” necessary for officials to worry about breakup risk and address some of the structural problems.
The US trade deficit narrowed in 2019 for the first time in six years. The trade deficit in goods with China declined $73.9 billion to $345.6 billion. It was the first drop on an annual basis since 2016. China lost its place as the top US trade partner, falling to third place behind Mexico and Canada.
In February, the US trade deficit narrowed to $39.9 billion, the lowest since September 2016. The goods deficit with China narrowed to $16 billion, the lowest since March 2009. If the US trade deficit continues to shrink, it will curtail the offshore supply of much-needed dollars—the monetary base for global trade and reserves—and create a much tighter liquidity environment.
The US budget deficit will be roughly $3.7 trillion for fiscal year 2020. In a full employment economy, in normal times, that would worsen the overall trade balance. The rest of the world would earn more dollars from a boost in US aggregate demand. But that is no longer the case. The pandemic is a severe demand shock and could lead to lower aggregate demand in future. A peak-to-trough decline in US GDP of 12 percent in the first half of this year is three times worse than during the 2008 financial crisis.
The global economic system thus faces unprecedented challenges. There is a global scramble for dollars going on. Rapid adjustments are unfolding.
A growing cohort of distinguished investors in our community still worries about emerging markets (EM). Should an acute dollar squeeze develop of a type last seen in the early 1980s, local currency bond spreads will spike amid sharp currency depreciations and capital outflows. The dollar will soar. Borrowing through domestic currency bonds and accumulating large FX reserves over the past decade has not insulated their financial systems.
The Fed has reactivated swap lines and introduced a facility accessible to many global central banks to repo their Treasury holdings for FX liquidity. However, many EM countries will still have to turn to multilateral support due to external financing needs and a lack of policy space to support their economies. Stress amplifiers have risen with Covid-19.
Source: Institute of International Finance
Some EM central banks have announced QE measures for the first time (Chile, Colombia, Czech Republic, Hungary, Indonesia, Israel, Philippines, Poland, Romania and South Africa). However, the amounts are not large enough to compensate for the exit of foreign investors.
Since the beginning of the year, EM countries have experienced record portfolio outflows, about $100 billion, exceeding the worst points of the global financial crisis. The gush of global capital that flowed into EM is reversing course to find a safer home. Between 2007 and 2019 the value of internationally traded EM corporate debt almost quintupled from $500 billion to $2.3 trillion.
China’s GDP shrank 6.8 percent year-over-year in the first three months of 2020, the first quarterly decline since at least 1992. The long-awaited Two Sessions will begin on May 21, but there is little prospect of China driving a revival of global growth.
Beijing has not relaxed its long-running effort to de-risk the financial system while previous spending sprees (2008 and 2016) have led to scads of misallocated capital. The result is China’s non-government, non-financial debt has ballooned to an estimated 210 percent of GDP, almost as great as Japan’s was at its peak.
China’s central bank governor, Yi Gang, has advised caution, “Aggressive stimulus may bring inflation risks and cause too rapid an increase in the macro leverage ratio.” It takes about five units of credit to raise China’s GDP by one unit as money has poured into unproductive investments to sustain growth—a decade ago the ratio was just 1.3 to 1.
If the political fallout from the pandemic leads to a breakdown in US-China relations, Beijing will be less committed to keeping the yuan steady. The currency will weaken under the influence of protectionist measures and expectations of further tariffs against China.
Rightly or wrongly, China will be seen as actively participating in a currency war against America. Once yuan weakness turns pervasive, the risk is that it leads to reflexive, self-fulfilling fears of a devaluation, which could trigger a cascading decline across global markets. China is the largest trading nation for over 130 countries. The corollary is China will be the final casualty of the dollar bull market.
Newton’s first law of motion states: an object in motion stays in motion unless acted upon by a countervailing force. It took global coordinated intervention in 1985 to bring the dollar down. In 2001, it took a sustained downturn in stocks, recession, and spiraling deficits because of mindless wars in the Middle East.
As it stands, the global macro backdrop presents more upside for the dollar. To quote Brad Sester, a senior fellow at the Council on Foreign Relations, “The dollar always has a competitive edge in the world unless you do really bad things to it.” The Fed and Congress need to do more “really bad things” to end the dollar’s dance.