In early October, I published my analysis on why the U.S. dollar is likely in a topping process and that my base case was that it would be weaker in 2020 and beyond.
You can read that analysis here. The summary is that the dollar has been strong for the past five years, despite its fundamental problems, due to a global dollar liquidity shortage and five years of deficit-driven GDP growth that allowed for such tight monetary policy in the U.S. compared to other developed nations. However, the strong dollar is eventually a self-correcting mechanism to the downside.
A strong dollar has made foreign buyers unwilling or unable to buy large amounts of U.S. Treasuries on net, especially among foreign central banks, which means domestic balance sheets have absorbed most of the $3 trillion in new federal debt issued over the past five years, until they were filled up to the limit that they can reasonably hold. Therefore, the Fed was forced to step in and is monetizing U.S. deficits and is expanding its balance sheet once again as a buyer of last resort, representing a major pivot in U.S. monetary policy and the end to the tight U.S. monetary conditions relative to the rest of the developed world.
The economic impact of COVID-19 on the world has been huge, and has exacerbated the global dollar shortage and brought it to a head. The Fed, however, has been forced to supply enough global liquidity to avoid a disorderly sale of U.S. Treasuries.
This article re-examines the topic and addresses the most common argument against the long-term dollar bear thesis.
The Monetary Pivot: Bond-Buying
Ever since the third round of quantitative easing (QE3) ended in late 2014, the dollar has been quite strong. In addition, the United States has been stimulating its economy with large 4-5% deficits as a percentage of GDP, while the Euro Area has been maintaining a relatively balanced fiscal budget overall.
In other words, the United States has had very loose fiscal policy and, compared to other developed countries, very tight monetary policy over the past five years, which is a recipe for a strong currency while it lasts. Europe has been the reverse, with tighter fiscal policy but very loose monetary policy, which is a recipe for a weak currency.
However, eventually all that deficit spending caught up with us, as the strong dollar and other factors have resulted in rather few foreign buyers of U.S. government debt, and domestic balance sheets can only hold so much of it. This was all described in my October article.
With domestic balance sheets tapped out and foreigners not buying enough, the Federal Reserve now has to be a huge buyer to fund those deficits. Cutting those deficits would be politically unpopular on both sides of the mainstream political spectrum and would be a headwind against U.S. GDP growth, so those deficits will likely persist for quite some time and the Fed is on the hook to buy them.
Since mid-September when the overnight repo market broke, and actually even a bit before that from August, the Fed has been a major buyer of U.S. Treasuries, and is now in the process of quickly reversing its entire 5-year period of tight monetary policy. Here is the Fed’s holding of U.S. Treasuries over time:
Chart Source: St. Louis Fed
As of this pivot, the United States has joined the rest of the developed world with very dovish monetary policy. Interest rates in the United States are still above others, but the U.S. central bank is injecting more liquidity and buying bonds at a faster rate than most of its peers at this point.
The biggest push-back I receive against my long-term dollar bear thesis can be summarized as follows:
Sure, the dollar has a lot of problems, but it’s the “cleanest dirty sheet in the hamper” as the saying goes. All other fiat currencies are even worse, with negative/zero interest rates and slower economic growth. So, the dollar may decline against something like gold in the long term, but why would it decline against other currencies?
That’s a reasonable line of thought at first glance. The answer to that question comes down to figuring out the hierarchy of metrics that eventually affect comparable currency strength.
Based on the most important long-term currency metrics that I’ll discuss in this article (short answer: a country’s balance of payments), the U.S. dollar is actually one of the worst major currencies, fundamentally. It just happens to be propped up at the moment by a global dollar liquidity shortage (because emerging market countries borrowed in U.S. dollars as the global reserve asset, so there is high demand for dollars to pay down the dollar-based debt) as well as the aforementioned five years of tight monetary policy.
Now that those five years of comparatively tight monetary policy have forcibly ended, the downside potential has opened up for the dollar over the coming years.
How to Win a Currency War
Back in the 1920’s and 1930’s, many countries including the United States engaged in “beggar thy neighbor” policies, meaning that with a combination of tariffs and currency devaluations, they attempted to gain trade advantages over each other. Tariffs on imports seek to make foreign producers less competitive, and currency devaluations seek to make their own country’s exports more competitive.
The challenge with such policies is that it’s a zero-sum game; each country can keep layering on additional protective policies or further weakening its currency until it all spirals out of control and they are forced to come to a truce.
Tariffs can potentially be used successfully for correcting problematic trade policies of specific countries (like, say, IP theft from China), but when countries use beggar-thy-neighbor policies against each other broadly and for their own advantage, it historically doesn’t go well, because everyone starts escalating them and therefore global trade diminishes.
Back then in the 1920’s and 1930’s, currencies were on a gold standard, and all the major ones were intentionally devalued against gold to various degrees to allow for money-printing stimulus to deal with the deflationary spiral of the Great Depression:
Chart Source: Bridgewater Associates on LinkedIn
With the on-again-off-again trade war between the United States and China, as well as hyper-dovish monetary policies by all major developed countries, there is increased risk of beggar-thy-neighbor policies, or the potential for a renewed currency war, in the 2020’s. Historically, currency devaluation has also been a primary method to address high debt levels in one’s own currency, with cycles of currency devaluation periodically used to inflate away unpayable debt levels every few decades without defaulting nominally.
That begs an interesting question. In an era where all currencies are fiat, printed as needed without tangible backing by a finite commodity and only limited theoretically by inflation risk, how does one win or lose a currency war? What stops countries from printing out of control? Which metrics lead to weaker currencies if each country goes “all out” trying to weaken their currency with zero or negative interest rates and trillions spent on bond-buying programs?
The answer, historically, is that the balance of payments between nations is the limiting factor, the top of the currency metric hierarchy. Structural trade deficits, and more broadly current account deficits, eventually lead to weaker currency until the trade deficit or current account deficit is reduced. All of the other details like interest rate differentials and money-printing are the ebbs and flows on top of that foundation.
A country’s trade balance is the difference in the amount of goods and services that they export compared to what they import. The current account balance is a broader measure, because it includes the trade balance but then also includes sources of income between countries.
For a simple example, if country A exports $300 billion per year to country B, and imports $200 billion per year back from country B, then country A has a $100 billion trade surplus with country B. If country A also owns a lot of real estate, equities, or bonds of country B, and receives $50 billion in various types of income from those assets per year, then the current account surplus is $150 billion in country A’s favor ($100 billion trade + $50 billion payments).
I wrote a detailed article, including a fun narrative in there, on why trade balances and current account balances matter.
The simple way to think about it is that a country’s current account represents the transfer of wealth. A country with a consistently positive current account balance has more wealth flowing into it, and generally begins developing a positive net international investment position, meaning they own more foreign assets than foreigners own of their domestic assets.
Traders often rightly ignore these payment balances because they take years to manifest in currency fundamentals. A nation can go for years with a large current account deficit, or decades in the case of the world reserve currency, before the deficit manifests in a sharply weaker currency.
However, if you’re an investor that focuses on long-term positioning, it’s time to dust off the balance of payments records, because thanks to this latest monetary pivot, they’re already starting to matter again.
The amount of money-printing that the Fed is likely to do in the coming years to fund growing U.S. government deficits, mainly related to structural health care, social security, and military spending (hard things to just “cut”) represents a major shift in U.S. monetary and puts our current account deficit back front and center.
The Global Balance of Payments, and Why it Matters
In the global financial system as currently structured since 1971 (i.e. post gold standard and with the oil-backed U.S. dollar as the primary global reserve asset), the U.S. dollar has had three major cycles of strength and weakness. We are currently in the third cycle of strength, which was driven by the aforementioned temporary combination of loose fiscal policy and tight monetary policy:
Chart Source: St. Louis Fed
Over time, the U.S. has shifted from being a net creditor to being a net debtor. Due to persistent trade deficits (currently around negative 3-4% of GDP per year) and current account deficits (currently around negative 2-3% of GDP per year), the U.S. has developed a net international investment position equal to about -50% of GDP. Foreigners own more U.S. assets than we own of their assets, and we continue to have an annual current account deficit leading to a deeper and deeper negative net international investment position.
Chart Source: St. Louis Fed
It’s not surprising, then, to see that the dollar has drifted downward over decades compared to a basket of major currencies in the chart above. Each cycle of strength has reached lower highs.
The Euro Area and Japan both have positive current account balances. Japan has a very positive net international investment position (about +60% of their GDP), while the Euro Area has a roughly balanced net international investment position (just -5% of GDP). China also has a positive current account balance and positive net international investment position.
Currently, the U.S. and the U.K. are roughly tied as having the largest twin deficits among the G7 nations, meaning the biggest combination of budget deficits and current account deficits as a percentage of GDP:
Data Source: Trading Economics & Various Government Sources
Fortunately for the United Kingdom, however, their net international investment position is only around -15% compared to the U.S. which is at -50%.
That is why I contest the notion that the U.S. dollar is the “cleanest dirty sheet in the hamper”. Based on the global balance of payments and net international investment positions, it is one of the worst.
And the reason this matters, is that it is hard to weaken a currency beyond the balance of payments threshold. We can use Japan from 2012 to the present as a case study in this regard.
For many decades, Japan had a positive trade balance and positive current account. Their disciplined and highly-educated culture has consistently produced more value than they consumed, even though they have historically had to import a lot of their energy and commodities.
However, they also experienced a declining workforce and an aging population. Their government deficit as a percentage of GDP became very high.
Starting in late 2010, Japan developed a trade deficit as well, which eventually reached a low point of about -2% of GDP in 2013 and 2014. Their current account balance dropped to as low as zero during this time; relatively flat compared to their historically normal surplus.
In order to fund large fiscal deficits and attempt to stimulate the economy, the Bank of Japan began a massive quantitative easing program in 2012. Over the next three years, they more than doubled the size of their already-large central bank balance sheet by buying bonds and other assets, and today it is over 100% of GDP (compared to about 20% for the U.S. Federal Reserve and about 40% for the European Central Bank). They made the U.S. Federal Reserve’s quantitative easing look like child’s play:
Chart Source: Trading Economics
In addition, the U.S. Federal Reserve stopped its quantitative easing program by the end of 2014, which resulted in tighter U.S. monetary conditions and a strong dollar as previously discussed.
In January 2012, near the beginning of this ramp-up in Japan’s QE, one dollar was equal to about 78 yen. By January 2015, the yen had devalued such that one dollar was equal to about 120 yen. In other words, the yen devalued by about 35% relative to the dollar. The yen also devalued against the euro and other major currencies, but not by as much. I marked January 2012 and January 2015 on this chart group for reference.
During that time, the interest rate on 10-year Japanese government bonds dropped from about 1% to nearly 0%. So, they performed an utterly massive bond-buying program combined with among the world’s lowest interest rates.
By 2015, the weakening yen had made Japan’s exports more competitive, and made imports more expensive, and thus it helped fix their trade balance back up to even (zero), and their current account balance to being positive once again.
Chart Source: Trading Economics
At that point, even though they continued massive quantitative easing, the yen stabilized against other major currencies. In fact, the yen has slowly strengthened against the dollar since then from its weakest point, despite continued hyper-dovish monetary policy in Japan.
Chart Source: XE
It is very hard to weaken your currency into a major trade surplus. Eventually, the fact that your current account balance is positive, and wealth is flowing into your country on net, keeps the currency from devaluing much further despite continuing to do actions (like maintaining low interest rates and printing money) that should otherwise drive down your currency’s exchange rates. The balance of payments is eventually the foundation of currency strength.
Switzerland has faced similar results in recent years. Armed with an extremely high current account surplus (nearly 10% of GDP) and a strengthening currency, they have set their interest rates into extreme negative territory and have printed enough money to build a central bank balance sheet equal to over 100% of GDP (mainly by buying foreign assets rather than domestic assets).
However, the best they could do from all of that is stop the Swiss franc from continuing to strengthen against the dollar. It has simply remained flat against the dollar for years, rather than weakening against it, even though the dollar had higher interest rates and the U.S. Fed was holding its balance sheet steady (and for a time, decreasing it).
Chart Source: XE
Turn the Question Upside Down
As previously discussed, investors that understandably disagree with the notion of a weaker dollar often point to these global comparisons, like lower interest rates and larger balance central bank sheets as a percentage of GDP in Europe or Japan or elsewhere, and say the dollar won’t go down because its competition is so weak.
After years of massive quantitative easing that has even included buying equities, the Bank of Japan’s balance sheet is equal to over 100% of Japan’s GDP and the Japanese government’s 10-year bond has a negative interest rate. The European Central Bank balance sheet is equal to about 40% of Euro Area GDP, their 10-year bonds range from negative to slightly positive, and there are even questions about whether the European monetary union will look the same as it does now in five or ten years.
Meanwhile, the U.S. Federal Reserve’s balance sheet is only equal to about 20% of U.S. GDP, and we still have 10-year yields over 1.8%.
However, keep in mind that this is how strong the dollar is with all of that already in place. The dollar hovering in the upper-90s dollar index (DXY) level is how strong the dollar became after five years of having the tightest monetary policy among developed countries.
I think investors are best served by turning the question upside down. From this point where we stand now, who has the most ammo to win a currency war, to devalue their currency intentionally or unintentionally against others from current levels?
Is it the countries with positive current account balances that already threw the kitchen sink at their currencies with zero/negative interest rates and massive bond-buying programs for years?
Or is it the country with a negative current account balance and the largest twin deficit in the G7 that has had five years of tight monetary policy fueled by deficit-driven GDP growth (a recipe for currency strength), and is just beginning, due to not having enough buyers of its large government deficits, to seriously loosen its monetary policy and print more currency like the others already have?
Japan and Europe already spent a lot of their currency-weakening ammo by dropping rates and buying bonds, but their primary foundations (current account surpluses) only let their currencies weaken so far. They can’t really drive themselves into higher and higher current account surpluses through currency-weakening alone.
The United States, meanwhile, has the shakier underlying currency foundation with structural current account deficits and a deeply negative net international investment position, and is just beginning to spend its currency-weakening ammo like the others already have. The natural direction of the dollar is down based on the global balance of payments, and it’s just a question of transient forces occasionally holding it up for periods of time. The main transient force, tight U.S. monetary policy, just ended.
Sure, there will likely be brief corrections higher in the dollar going forward, including flights to safety or moments of tight liquidity. In particular, I consider there to be a decent chance of one more deflationary dollar spike upward if the global economy turns down in 2020, which I would expect to be brief and painfully self-correcting. That may provide for buying opportunities in low-cost commodity producers, certain emerging markets, and similar dollar-sensitive investments.
Ever since the Federal Reserve was forced to pivot its monetary policy to a more dovish approach, the structural balance of payments that exists in global trade likely points to a weaker dollar in the coming years, with various bumps up and down along the way. If that outcome occurs, it would likely be bullish for many commodities and emerging markets for a multi-year period in the 2020s, which have underperformed over the past decade.
Check out these articles for further reading: