The dollar can only escape bad US policy for so long
Having the world’s reserve currency has allowed the US to make policy mistakes with near impunity
Jan Dehn
© Reuters
The US government has committed three serious policy mistakes since late 2017. In December that year Congress cut taxes just as the US economy attained full employment. Then, in April 2018, the Federal Reserve turned hawkish as it mistook the temporary sugar high from the tax cut for a higher trend growth. A month later, President Donald Trump abandoned America’s longstanding commitment to free trade by imposing a broad range of tariffs on Chinese imports.
Despite these policy errors, the dollar rose. If any other country had done the same thing, it would have been severely punished in currency markets and probably downgraded by credit rating agencies.
Why can the US act in this manner with apparent impunity in the markets? The answer lies in the dollar’s status as the world’s pre-eminent global reserve currency. Such a status is like insurance — it guarantees access to finance in bad times. The US can access finance even when it causes crises, as in 2008-09. It even determines the size of its own insurance payout by setting the amount of Treasuries it issues. Financial regulations contribute to the dollar’s special status.
US government bonds are assigned a 0 per cent risk rating under Basel III because they are considered risk free. Rating agencies do their bit by assigning higher ratings to the US bonds than to bonds in less indebted, faster growth countries without reserve currency status. The cherry on top: central banks earmark more than 60 per cent of the world’s $11tn of forex reserves exclusively to the dollar.
However, these big advantages do not guarantee that the dollar, a freely floating currency since October 1976, will keep its value. The policy mistakes since late 2017 now weigh on the greenback, which is down this year despite European and Chinese economic weakness.
The dollar may struggle in the medium term as well. Foreign investors accumulated large dollar positions during the era of easy money to participate in the US stock market rally. These positions will now unwind. The US economy has recovered to the point where costs are eating into US company earnings. Higher company costs erode the scope for further capital gains, especially in the context of stagnant productivity, which can be attributed to US companies buying back shares in preference to investing in their own capital stock.
Without prospect for significant capital gains, total return in the US stock market will therefore increasingly derive from dividend yield, which is many times lower than the yield available on, say, bonds in higher yield markets, such as EM. The unwind of dollar longs will eventually subside, but only after US companies have restored a competitive edge; this happens when the dollar is about 20 per cent lower than today.
The dollar faces a mounting time inconsistency problem. The US economy is heavily indebted and unproductive, but Mr Trump shows no inclination towards austerity and meaningful reform. He sees more political upside in restoring American competitiveness by inflating and debasing the dollar. This is why he leans heavily on Fed chairman Jay Powell to lower rates, supports strong pro-cyclical fiscal spending and frequently talks down the currency. Such policies are not consistent with a strong dollar.
Indeed, the last time the US pursued similar policies was in the 1970s, when Fed governors Arthur Burns and William Miller oversaw a 50 per cent decline in the dollar, 10 years of high inflation and negative real interest rates. Mr Trump’s inflationary policies will rob future generations of Americans of their savings and dollar weakness will inflict losses on central banks. It is not pretty, but, politically, inflation and currency weakness are seen as a beautiful way to solve America’s economic problems.
If Mr Trump deliberately “burns” America’s reserve currency status, his timing may be not bad at all. The trick: to avoid a disorderly dollar collapse. As long as Europe struggles with inherent tribalism and China faces deep-seated prejudices neither the euro nor renminbi pose immediate challenges to the dollar’s hegemony. The dollar looks most likely to lose ground against smaller developed market currencies and emerging market currencies. If the US slowdown is gentle, EM currencies will outperform higher beta developed currencies, such as the Canadian and Australian dollars and the Norwegian krone. If the US slowdown becomes more intense, there may be more near-term support for the Swiss franc, Japanese yen, gold and even bitcoin.
At root, the dollar’s reserve currency status depends on American willingness and ability to lead. As America shrinks from global leadership, it is prudent that all investors begin to take currency diversification far more seriously than they have done in recent years.
Jan Dehn is head of research at Ashmore Group
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