Markets decided after the 2020 US election result that a Biden presidency with a divided Congress would be friendly to asset markets and help the US dollar lower, giving the Fed a maximum dovish tilt as the political gridlock was seen as perhaps holding back more generous stimulus. And at first blush, the USD bearish case was not immediately damaged by the Democrats taking control of the Senate by the slimmest possible margin after winning both of the seats up for grabs in the Georgia Senate runoff races. This “Blue Wave Lite” scenario takes the pressure off the Fed to provide all of the support for the economy as investors can conclude that the Congress has enough votes, likely from both sides in many cases, for uncontroversial and large-scale fiscal stimulus for individuals, small businesses and infrastructure building. But with very weak control of the Senate and more tenuous control even of the House, the Democrats will likely struggle to get the votes for corporate tax reform or a deeper climate agenda.
Indeed, politically, the balance of 2021 will be all about getting to the other side of the pandemic and an increasingly aggressive vaccination rollout as production and logistics issues are ironed out in Q1 and Q2, and before fall sets in. In the meantime, with yawning US deficits stretching out over the horizon and the stimulus check and other fiscal support only feeding ever-larger US external deficits, eventually inflation should begin to rise and real interest rates fall. The effects of the Covid-19 policy response are clear if we take a look at the US trade deficit for example. The most recent available US trade deficit number from November was reported at over -$68 billion, the second largest on record, and far and away the largest ex Petroleum – likewise at -$68 billion due to the relative energy self-sufficiency of the US. For perspective, the 24-month rolling average for the headline trade balance before March of 2020 was less than -$50 billion. With treasury issuance next year soaring beyond the Fed’s current level of announced purchases, there will be fewer buyers willing to absorb this torrent of new paper; especially if US consumers are in a spending mood, ready to get out and have some fun after a year of lockdown and caution for so many.
Added stimulus only adds to deficits because in the case of the US, especially in a lockdown when services activity is reduced, stimulus largely ends up in purchased manufactured goods produced in China and elsewhere. In fact, CNY strength was one of the biggest FX stories in the second half of 2020, helped by a supercharging of export demand that also allowed the PBOC to maintain a relatively tight monetary policy in the interest of deleveraging portions of its economy. A kicker besides higher policy rates and the carry implications was the spectacular rise in the Chinese equity market. More below on China, but we doubt if the renminbi is in for a repeat performance in the near term, because any pronounced further strength in the currency could bring with it a host of challenges for China, especially further loss of labour- and export-price competitiveness, even if the strength helps to offset some of the rise in internationally sourced commodity prices. Stability perhaps; isolated strength, not so much.
Chart: US trade imbalances and the US dollar
There may or may not be a lagging effect in the US dollar (JP Morgan real effective USD in yellow in chart below) from huge external imbalances (the US monthly trade balance shown in black). Back in the late 1990s and the early 2000s the US attracted so much capital because of the booming stock market as Clinton managed to balance the nation’s books in his second term. The USD then perhaps held on to its gains on the subsequent safe-haven trade as the tech bubble unwound and the market attitude to the newly launched euro was sceptical. As the 2000s wore on the growing external deficits finally began to weigh on the US dollar. Deficits were driven by the loss of the US manufacturing base to China and elsewhere, and a rising oil price together with expanded energy demand but declining domestic energy production. Now, when the US stimulates, as it did after the Covid-19 pandemic broke out, the stimulus goes straight to the trade deficit. Unless the US can find a way to offset the outflows with incoming capital inflows, the worsening external balances will wear further on the US dollar.
That brings us to the potential spoiler for an easy path lower for the US dollar, despite the compelling fundamentals for the USD bearish case noted above: a steepening yield curve and a further rise in US long yields, which broke higher above key thresholds – like 1.00% for the US 10-year Treasury benchmark – in the first week of 2021. All other things equal, higher yields are a form of tightening of financial conditions, and globally so as the USD is the reserve currency. Sure, this can reflect better optimism about the economic outlook, but given the enormous further growth in debt from the Covid-19 response, the level at which higher rates become a problem has dropped sharply just as it has for every cycle since the 1980s. Recall that by late 2018, a 3.0+% US 10-year yield and a tapering Fed with its 2-2.25% policy rate virtually broke financial markets and forced the Fed to reverse course. On top of that, global markets by the end of 2020 had lurched into a speculative frenzy in some corners of the market, and higher yields would erode the justification for sky-high multiples of the most popular and speculative growth companies.
Whether the level that gets markets into trouble is 1.25% or above 1.50% in the US 10-year benchmark, trouble lurks…unless the Fed does what it has hinted its next policy might be if rates rise before labour markets have normalised: yield curve control, or effectively, capping longer treasury yields. It’s certainly possible, but the Fed may have a hard time rolling out yield caps or “yield curve control”, if sharply rising price pressures begin to show up in a rapidly recovering economy and improving labour market conditions. In short, asset market volatility becomes an accelerating risk with every tick higher in long yields; would the Fed risk the turmoil of a yield curve control move with financial market conditions easier than they have ever been? The smoothness of the greenback’s descent in Q4 may not repeat in Q1.
In the Goldilocks scenario for USD bears from here, US yield rises will prove muted and EM and commodity currencies will continue to put in a stellar performance on normalisation as the weather warms and vaccines are administered at high volumes. From a valuation and carry perspective the Turkish lira is compelling if Turkey can avoid geopolitical quagmires. Other winners in a reflationary recovery could include the South African rand and Russian ruble, although geopolitics are a very prominent risk for the latter under a US President Biden. Within the G-10, the commodity currencies are less compelling than they were before their recent blistering ascent, although they should do fine in a reflationary recovery. Also, there is still value in NOK if oil prices continue to normalise. In G3, besides the extensive USD coverage above, the euro benefits from global growth normalisation on the export side, but is dragged by less generous domestic stimulus and a negative policy rate, while the JPY hates higher yields and tends to track the US dollar in the crosses. Sterling is a tough call: structurally, there are the same negatives as for the USD, but its valuation is in a completely different post code – so its ceiling may prove somewhat low in a recovering economy.
Biggest global monetary shift in several generations under way?
Longer term, the key challenge for the US dollar could become downright existential if the world begins to lose trust in the “faith and credit” of the US Treasury. This challenge could come from two directions. The first of these would be the prospect of negative real interest rates, in which overuse of the printing press on the fiscal side results in high inflation that is not sufficiently offset by the policy rate – say 4% inflation with a 1% Fed Funds rate. The rise in gold, bitcoin/crypto assets, hard assets of any kind and the sudden increase in monetary velocity caused by an exodus from USD-linked former risk-free assets like T-bills and treasuries, could theoretically even trigger an outright USD crisis.
Secondly, there is the challenge to the US dollar as the sole real global reserve currency in the shape of a China that is looking to replace the US dollar in its trade relationships with the outside world. It’s doing this both as a means of attracting global capital as it has achieved the status of global power on a par with the Euro bloc and the US, but also to avoid vulnerabilities to its financial system if the US weaponises the US dollar and its effective control of the global financial system in an attempt to thwart China’s rise, given that the rivalry between the two powers will only escalate from here. The instrument with which China is attempting this transformation of the renminbi to global currency status is the DCEP, the Digital Currency Electronic Payment framework or “digital yuan”. Already in trial runs in parts of China, the DCEP will be pivotal in its so-called dual circulation policy of maximising domestic growth while continuing to open its economy and capital markets to the world. A successful rollout of the DCEP in coming years could be the most momentous change to the global monetary system since the Bretton Woods system was created back in the dying days of WWII at Bretton Woods.
Quarterly Outlook Q2 2022: The End Game has arrived
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