Why the Dollar Is More Robust Than It Looks

It’s about as hard right now to find anyone with a kind word to say about the greenback as it is to find someone with a nasty word about equities. There is much talk of yawning U.S. budget and current-account deficits. Extreme fiscal policy has been added to extreme monetary policy.

Reasonable people might wonder about inflation and vertiginous asset prices, but reasonableness is seemingly not in high demand in Washington. The Treasury and the Federal Reserve seem to want to print as many dollars as they can. Inflation is going up and the dollar down. Real yields, as reflected in the yields on Treasury Inflation-Protected Securities (TIPS), have fallen ever lower over the last year as expected inflation has risen. The yield on five-year TIPS recently touched a little less than -3%, a record low. Thus has the trade-weighted dollar fallen by about 12% since its high in the spring last year, and many think it has a lot further to fall.

While I buy some of this argument, I don’t believe it’s the fault of current-account and budget deficits: They’ve been a fact of life in the U.S. for years. The dollar has sometimes gone up and sometimes gone down but you’d be hard-pressed to see a relationship between movements in the currency and movements in those deficits.

It always astonishes me, moreover, when people look at only one side of the equation — the U.S. — without looking at what’s happening elsewhere. Currencies, after all, are relative not absolute prices. Real yields have also fallen in the U.K. and the euro zone. Five-year U.K. real yields are also a little under -3%. Although they’ve dropped by less than in the U.S., you need to take this with a pinch of salt as Europe’s markets are even more illiquid and manipulated than they are across the Atlantic. The U.K.’s own rather dramatic budget and current account deficits haven’t stopped sterling from soaring. 

I would frame the dollar’s problem differently. It peaked in March last year at the same time as risk appetite troughed. The greenback has fallen sharply in part because there was an acute shortage of dollars before, and the Fed — through printing money and creating more swap lines to other central banks — made very sure that the shortage became a surplus. At the same time, Asian currencies flew because the region’s economy has been fizzing and commodities are on a tear.

Moreover, the cost of being short dollars against countries and regions with negative interest rates fell dramatically last year, since the Fed pushed down short rates much more than, say, the Bank of Japan or the European Central Bank. It now costs only about a quarter of a percentage point to be long euros and short dollars for three months. For the yen, it costs just about nothing.

For any currency with an interest rate, carry has been king as investors borrow in dollars and other cheap currencies and snap up higher relative rates. The South African rand, for example, has soared. Even the Turkish lira has recovered its poise. Far and away the most popular currency for dollar investors, though, has been the Chinese yuan, for which investors — especially the leveraged sort — are currently paid almost 4.5% more than dollars for three months.

Looked at through this lens, the dollar looks potentially more robust to me. As anyone who’s managed a currency portfolio knows, you don’t really worry about movements in inflation but movements in interest rates. And things might be about to shift upward on the latter for the dollar. Even though the relative move higher in U.S. short rates has been meager so far this year, an expectation of higher dollar rates has already steadied the greenback. If we get more numbers like last week’s U.S. retail sales and producer prices, both much higher than expected, markets will bet that even the perennially dovish Fed will have to take note.

I think the U.S. will grow more quickly than the rest of the developed world this year and rate expectations will thus keep moving in the dollar’s favor.

The next shoe to drop will be risk appetite. Emerging-market currencies have a strong relationship with overall risk conditions. When this is buoyant, EM currencies generally float, too. But some of these trades are very crowded and many will do badly when risk appetite sours.

The carry is already much less than it was as investors have piled into the yields available in emerging markets, driving them lower. Many popular longs are in currencies that you’d struggle to define as liquid. The exception might be the Swiss franc, seemingly everyone’s favorite short, a currency that tends to do well when times are  bad — and which has a history of inflicting large losses on those who are short.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Richard Cookson was head of research and fund manager at Rubicon Fund Management. He was previously chief investment officer at Citi Private Bank and head of asset-allocation research at HSBC.

©2021 Bloomberg L.P.

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