Markets Insight
March 18, 2013 12:22 pm
Rising dollar marks big investment shift
Investors have come to regard a weak US dollar as an essential part of the low real rate, high capital flow backdrop for about a decade, but things are starting to change.
The US dollar has had a spring in its step this year, with the dollar index, a weighted composite of the dollar’s strength versus its trading partners, rising almost 4 per cent. This is likely to be the “amuse-bouche” of a more substantial meal of appreciation that could go on until 2015, marking a big shift in the investment environment.
A change in US dollar direction would be important partly because it has form. Since the collapse in 1971 of the Bretton Woods Agreement, a system of fixed exchange rates, the US dollar has been through three downwaves (1968-78, 1985-92, and 2001-11) and two upwaves (1978-85 and 1992-2001), with an average duration of a little over seven years.
The first appreciation phase helped to bring down Latin America. The second helped to bring down Asia. Despite several causes, a common factor in Asia was the desire to keep currencies pegged to the US dollar, in spite of its 50 per cent rise against the Japanese yen. During both phases, commodity prices in US dollar terms performed badly.
This time, with the yen falling and likely to drop considerably further, it is much more likely that Asian countries will lean with the yen rather than the US dollar. Policy regimes have changed, and respite from a weak US dollar will allow local central banks to unwind monetary distortions created by currency intervention funding mechanisms used to mitigate a weak US currency. But a strong US dollar is also likely to be associated with more unstable capital flows and a rise in inflation, leading to some reactive tightening of monetary policy.
Emerging markets will also be highly sensitive to the slowing trend in Chinese growth. The economy is still rumbling along at about 8 per cent, but the irresistible forces of rebalancing and other discontinuities, including those related to the environment, credit creation and public social policy, point to slower growth over the next few years, one way or another.
At the very least, China’s growth is going to become less commodity-intensive. This will have important effects on industrial and mining commodity exporters and countries, which have profited in recent years from the China effect on commodity prices.
Commodity and emerging market assets are not only US dollar- and China-linked, but have also been the object of “financialisation” in recent years, as banks created products for investors in response to the proliferation of zero rates and quantitative easing in advanced economies.
This puts the Federal Reserve on centre stage, even if its Japanese and European counterparts look committed to further significant expansion of their balance sheets. This is not to suggest any change in the Fed’s asset purchases is imminent, especially as fiscal drag continues and the unemployment rate still stands at 7.7 per cent. But the ground is starting to shift, and with it, the US dollar.
The positive market reaction to the February employment report was illustrative. But in addition to a pick-up in the hiring rate, housing and construction activity is improving, and capital spending and exports are both contributing more to gross domestic product growth.
Competitive edge is also beginning to return to the US. The current account deficit is now a manageable 3 per cent of GDP.
Exports of goods and services have risen to a record 14 per cent of GDP, with good gains in advanced manufacturing. Net energy imports are falling. And based on relative unit labour costs, the US is now the most competitive country in the OECD, except for South Korea, and making big gains against China.
If US debt and the country’s ugly fiscal politics are a negative for the US dollar, and US assets, as often claimed, the markets have a funny way of showing it.
This is not to deny the issue of debt sustainability issues from the end of this decade onwards, or the capacity of politicians to upset financial market sentiment. But for now, the US budget deficit is falling. At about 5 per cent of GDP in 2013, it will be half of what it was in 2008 and, given current laws, double what it will be in 2015.
The contrasting economic and financial conditions of the US vis a vis Japan and Europe could not be starker. The US dollar should be expected to trend higher against most leading currencies, and put industrial commodities and emerging market currencies and local debt under pressure. Some reversal of the significant diversification away from the US dollar in the past decade by asset managers, central banks and sovereign wealth funds appears justified and probable.
George Magnus is an independent economist, and senior economic adviser to UBS
.
The US dollar has had a spring in its step this year, with the dollar index, a weighted composite of the dollar’s strength versus its trading partners, rising almost 4 per cent. This is likely to be the “amuse-bouche” of a more substantial meal of appreciation that could go on until 2015, marking a big shift in the investment environment.
A change in US dollar direction would be important partly because it has form. Since the collapse in 1971 of the Bretton Woods Agreement, a system of fixed exchange rates, the US dollar has been through three downwaves (1968-78, 1985-92, and 2001-11) and two upwaves (1978-85 and 1992-2001), with an average duration of a little over seven years.
The first appreciation phase helped to bring down Latin America. The second helped to bring down Asia. Despite several causes, a common factor in Asia was the desire to keep currencies pegged to the US dollar, in spite of its 50 per cent rise against the Japanese yen. During both phases, commodity prices in US dollar terms performed badly.
This time, with the yen falling and likely to drop considerably further, it is much more likely that Asian countries will lean with the yen rather than the US dollar. Policy regimes have changed, and respite from a weak US dollar will allow local central banks to unwind monetary distortions created by currency intervention funding mechanisms used to mitigate a weak US currency. But a strong US dollar is also likely to be associated with more unstable capital flows and a rise in inflation, leading to some reactive tightening of monetary policy.
Emerging markets will also be highly sensitive to the slowing trend in Chinese growth. The economy is still rumbling along at about 8 per cent, but the irresistible forces of rebalancing and other discontinuities, including those related to the environment, credit creation and public social policy, point to slower growth over the next few years, one way or another.
At the very least, China’s growth is going to become less commodity-intensive. This will have important effects on industrial and mining commodity exporters and countries, which have profited in recent years from the China effect on commodity prices.
Commodity and emerging market assets are not only US dollar- and China-linked, but have also been the object of “financialisation” in recent years, as banks created products for investors in response to the proliferation of zero rates and quantitative easing in advanced economies.
This puts the Federal Reserve on centre stage, even if its Japanese and European counterparts look committed to further significant expansion of their balance sheets. This is not to suggest any change in the Fed’s asset purchases is imminent, especially as fiscal drag continues and the unemployment rate still stands at 7.7 per cent. But the ground is starting to shift, and with it, the US dollar.
The positive market reaction to the February employment report was illustrative. But in addition to a pick-up in the hiring rate, housing and construction activity is improving, and capital spending and exports are both contributing more to gross domestic product growth.
Competitive edge is also beginning to return to the US. The current account deficit is now a manageable 3 per cent of GDP.
Exports of goods and services have risen to a record 14 per cent of GDP, with good gains in advanced manufacturing. Net energy imports are falling. And based on relative unit labour costs, the US is now the most competitive country in the OECD, except for South Korea, and making big gains against China.
If US debt and the country’s ugly fiscal politics are a negative for the US dollar, and US assets, as often claimed, the markets have a funny way of showing it.
This is not to deny the issue of debt sustainability issues from the end of this decade onwards, or the capacity of politicians to upset financial market sentiment. But for now, the US budget deficit is falling. At about 5 per cent of GDP in 2013, it will be half of what it was in 2008 and, given current laws, double what it will be in 2015.
The contrasting economic and financial conditions of the US vis a vis Japan and Europe could not be starker. The US dollar should be expected to trend higher against most leading currencies, and put industrial commodities and emerging market currencies and local debt under pressure. Some reversal of the significant diversification away from the US dollar in the past decade by asset managers, central banks and sovereign wealth funds appears justified and probable.
George Magnus is an independent economist, and senior economic adviser to UBS
.
Copyright The Financial Times Limited 2013.
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