For the past eight years the U.S. dollar (USD) has been on an upward trend, rising substantially against most of its peers. Support came from three sources:
1. An improving U.S. fiscal situation from 2010 to 2016.
2. Substantially tighter monetary policy since 2016.
3. Stronger U.S. growth than in Europe and Japan, especially in 2011-13, and since 2017.
The first of the three sources of support for the dollar was undercut in 2017 when the U.S. budget deficit expanded from 2.2% of GDP in 2016 to 4.7% by mid-2019. Additionally, despite recent protectionist measures, the U.S. trade deficit has expanded, rising from 2.5% to 3.0% of GDP. This has taken the so-called “twin deficits” from 4.7% to 7.7% of GDP.
Figure 1: The Dollar Index Often Follows the Twin Deficits
The market is pricing that the Fed will cut interest rates up to four times over the next year (Figure 2) but, so far, the Fed itself hasn’t committed to such a drastic policy action, only opening the door to a possible rate cut. Nevertheless, U.S. monetary policy probably will no longer be a source of support for the USD in the year ahead, unless there is a dramatic change in rate expectations.
Figure 2: Fed Funds Now Price 75-100 bps of Rate Cuts in the Next Year.
So, if USD suffers another decade-long bear market in the 2020s, like it did from 2002 until 2011, who benefits? Which currencies would be most likely to go higher?
1. The British Pound (GBP): GBP is undervalued against the dollar and the euro mainly because of the uncertainty that surrounds Brexit. Traders fear a worst-case scenario: the pound collapses on or around October 31, 2019, if Britain has a no-deal exit from the EU. This is possible but even under the worst-case scenario, one must remember that in the long term there is no such thing as a no-deal exit. If Britain leaves without a deal, its very likely that in subsequent years there will be a deal that will look a great deal like what Theresa May negotiated and the pound will rebound strongly.
2. The Japanese Yen (JPY): the Bank of Japan has negative interest rates and it also intentionally weakened its currency during the middle of the last decade through a massive quantitative easing (QE) program that took its balance sheet to nearly 100% of GDP – more than 2x the ECB’s and nearly 4x the Fed’s relative to the size of their economies. With inflation barely positive and economic growth stalling, Japan doesn’t need a stronger JPY.
3. The Euro (EUR): with inflation stuck near 1%, a full point below the US and Britain, the eurozone doesn’t need a strong currency much more than Japan but that doesn’t mean that they won’t eventually wind up with one. The ECB has deposit rates at -0.40%, which translates into a 7.5 billion EUR per year tax on banks. Not surprisingly, the banking system is suffering, and credit is surprisingly difficult to obtain despite the extremely low rates.
4. The Indian Rupee: INR could also be an outperformer. India has a services-oriented economy that continues to grow quickly. Unlike China, it has low debt and unlike Brazil and Russia, it’s a commodity importer. Moreover, it has a significant positive interest rate differential with the rest of the world.
5. The Chinese Renminbi: Unlike, GBP, CHF, JPY and even EUR, RMB is not such a great candidate for strength versus USD. During the next decade, China is likely to see negative growth in its working-age population and a slowing of the rural-to-urban transition. It also faces a crushing debt burden. RMB is closely connected to USD and if USD falls a great deal during the 2020s, it will likely take RMB down with it.
Bottom Line
- The U.S. dollar could weaken because of bigger deficits, lower rates and slower growth.
- British pound may be undervalued because of Brexit and susceptible to a long-term rally.
- It may be hard for central banks to further devalue Euro, Swiss franc and Yen.
- Among emerging market currencies, the low-debt, not-commodity-dependent Indian rupee may be a winner.
Reference: CME Group
Thai
Eng