The US Dollar has certainly been on the back foot for the last three months, as can be seen in chart 1 below, showing the performance of the Broad Trade Weighted Dollar. However, the picture is a bit more nuanced than a broad index. Against the Euro and Yen, the Dollar was pretty flat for most of last year, with the weakest currencies generally being the commodity linked and emerging market currencies. During the period of recent Dollar weakness, it is the commodity and EM currencies that have rallied most, along with the Yen.
Chart 1 – The Broad Trade Weight US Dollar Index
As we all know the strong Dollar, especially against Emerging Market currencies, actually became a problem for the Global economy and financial markets last year. So it has been seen as a huge relief that the Dollar has been relatively weak in the last three months. Although we are looking to try and position for a strong Dollar in the weeks/months ahead, we would also point out that a strong Dollar, if that is what happens, will have a marked impact on the Global economy and financial markets. Put simply, if we are right about the Dollar, this will be a big thing for all markets.
Our main case for a strengthening Dollar rests on two issues. First, the backtracking on rate rises by the Fed is now widely acknowledged and we think pretty much priced into markets. Second, although we can point to structural problems in most countries, we believe that the US is probably the least challenged in the long term. Or put another way, we think that some of the structural issues in other countries may well be about to become a problem in the near future.
We haven’t written about Japan for some time, however, the fiscal and demographic problems there are simply too great for an easy and elegant resolution. Perhaps one of the scariest charts we have seen of late is chart 2 below showing the trends in Government debt per person and the ageing dynamic.
Chart 2 – Japanese debt per person and per cent of population aged over 65
As can be seen, debt per person is approximately US$90,000 equivalent. This is a staggering number. This debt has to be serviced, and with more retired people, there are fewer workers earning an income from which to pay taxes and service the national debt. Despite debt per person being a staggeringly high number already, this will continue to accelerate higher as debt to GDP will keep rising in the years ahead and the population is declining and will do so for decades to come.
Of course the Bank of Japan and the Government know the above dynamics, and although they have tried all conventional and a few unconventional policies, we do fear that they are not that far away from trying something silly – probably not at their meeting next week, but not far away. With negative interest rates up to and past 10 years on the bond curve, Japanese institutional investors are having to take on increasing risks to hunt down positive yields, and may increasingly invest abroad to do so.
The tipping point will be reached if they do manage to create inflation and investors simply abandon Japan to protect themselves from negative real interest rates. So although the Yen has been incredibly strong, perversely on the back of the move into negative rates by the BoJ, we do not think this makes sense in the big picture. We have a small short Japanese exposure in our portfolio and will be looking to add to it if we see the right market signals.
Chart 3 – The US Dollar versus the Japanese Yen
For the Eurozone, we are worried that the banking problems and lack of a coherent political structure will become a focus again for markets. It appeared to us at last week’s ECB meeting that Draghi seemed a little resigned to the potential that they have eased policy pretty much as far as they can, and as he said, we need to give these measure some time to work. He was also at pains again to say that monetary policy alone cannot fix some of the problems of the EZ. Perhaps investors may realise that even Draghi’s “whatever it takes” is not enough to overcome structural problems, and again with interest rates so low (negative on a huge amount of debt), we think capital will search out higher yields elsewhere over time.
Chart 4 – The Euro versus the US Dollar
We won’t go through all the charts today, but if we are correct that the Dollar is beginning to show signs of life against the Yen and Euro, then this should be enough to derail the recent strong rally in both commodity and Emerging Markets FX. Which brings us back to other markets, and their link with the Dollar.
Now it may not happen overnight, but if the Dollar strengthens, then investors will at some point revert back to thinking about the problems that seemed more immediate late last year and early this year. Also, the short term correlations, as seen in chart 5 below, indicate that the link between the Dollar and Global equities is as strong as ever.
Chart 5 – Global equities and the Broad Trade Weighted Dollar Index
We could easily be wrong about the Dollar in the very short term, and perhaps a continually dovish Fed (let’s see what their say at their meeting this week) will lead to a continued weak Dollar. However, Janet Yellen does not seem to be leading a united committee. Their goals have all been broadly met, financial conditions are easier than when they raised rates in December and inflation could be heading smartly higher by the Summer. Despite the market pricing in one rate rise this year at most, we can see a scenario in which the Fed is a bit more active.
So to conclude, after a pretty tough three months for the US Dollar, we think the tide is turning especially when we consider some of the structural problems affecting other countries. We will look to add bullish Dollar positions in our portfolios if market signals confirm that the Dollar is indeed turning higher. A strong Dollar would only increase our concerns about equity and credit markets.
Stewart Richardson
Chief Investment Officer
