Summary: US dollar bulls are focussed on the unwinding of QE3, but there are other reasons for a soft greenback: it helps the US to be competitive again; strong US data leads to increased foreign investment by US entities; global stabilisation encourages foreign selling of US bonds; and trade deficits are likely for many years.
|Key take-out: US dollar to return to parity.|
|Key beneficiaries: General investors. Category: Economics and strategy.|
This week saw the start of a potential major shift lower in the value of the US dollar. The US dollar strengthened significantly before – and after – the Federal Reserve Chairman Ben Bernanke’s speech about tapering. Again this week, the currency markets reacted to Bernanke’s update on the need to keep stimulus in place for the foreseeable future. However this recent volatility over the Fed Chairman’s comments masks a deeper fundamental reality.
Since early 2009, I have argued that the US would enjoy a strong economic recovery, and this was at a time when most were expecting a further significant deterioration in both the global and US economies. That seemingly bold prediction has largely been justified by events, but it is crucial to understand that the reasons behind a strengthening US economy, involve a weakening US dollar.
It was always felt that a Grand Bull Market in equities would be due to the relative strength of the global economy to the US, thereby generating strong revenue streams to America’s global corporations, which would also be further amplified by a soft greenback. This is the scenario that has largely played out, but more recently market sentiment has become overly obsessed with the timing of “tapering”. We all know QE3 must come to an end. The only question is when?
Drivers of a low US dollar
The problem, or opportunity for savvy investors, is that the markets have deemed US dollar weakness to be wholly a function of quantitative easing. As the end of QE3 has come into sight, virtually all the world’s currency speculators have been buying the US dollar aggressively. The US dollar had become extremely over-bought, which is why this week saw such a sharp sell off when Bernanke made it clear that stimulus measures would remain in place for as long as needed. Bernanke’s comments should be seen as the catalyst rather the cause however, as any bearish news item would have had a similarly dramatic impact.
The real reason for expecting the US dollar to continue to decline, is ironically the very strengthening of the US economy, and not just because of what that means for quantitative easing. Over the past several years the US basically repatriated whatever foreign investments it could, out of fear of a more significant global economic meltdown than actually occurred.
The investment void that was left behind was quickly filled by China. Now that the world is on a far more stable footing, and in recognition of this strategic error, the US is again keen to reach out and invest globally. For private institutions and investors to do so however, requires confidence, and that confidence paradoxically comes from better economic data in the US. The better the US economy performs, the greater the foreign investment by US entities.
Shifting investment flows
We are all aware of the now record levels of fresh investment flow into the major fund managers of the world, and how much of the flow toward equities is coming from bonds as well as cash. This is only to be expected, but this process also includes foreign holders of US bonds recognising they no longer need to be playing safe in the US, and they are bringing those funds back to their own markets. There is no doubt there is already significant bond sale investment flow out of the US, and that this process is likely to intensify in coming months. Institutions and investors around the world are also increasingly aware of the opportunities unfolding in Asia, and even Europe.
The latest US trade data also shows a continuation of the well established deficit trend, which is unlikely to change any time soon. The US administration has been aware for some time, that to be competitive again the US needs a lower dollar.
Subsequently I have been describing the “strong dollar” policy of the US, as the “orderly decline of the dollar” policy, for many years now. The US could never abandon the “strong dollar” policy as this would lead to a serious and immediate dislocation in global financial markets. It can however maintain the rhetoric, while never actually doing anything to halt the slide. The US dollar has already fallen from a high of EUR/USD 0.82, to around EUR/USD 1.31. The US is clearly not unhappy with the long-term fundamental shift in the value of its currency to much lower levels.
In summary, while the US dollar bulls are all excited about the end of quantitative easing as a reason to buy the greenback, working away in the background are a few other equally or more powerful bearish factors.
- Strong US data leads to increased foreign investment by US entities.
- Global stabilisation encourages foreign holders to sell their US bonds.
- Trade deficits are likely to continue for many years.
- The US benefits from a soft USD, hence a hollow “strong dollar” policy.
Basically as the global economic outlook continues to stabilise and improve, the US dollar will come under increasing pressure, and all that has been stopping a sharp decline to this point, is the huge swell of speculative buying based on the end of quantitative easing. The moment that speculative buying begins to retreat, the US dollar will, and most likely has already, begin a sustained period of decline. The US dollar can be reasonably expected to decline some 15% over the next 18 months, if not sooner.
The beneficiaries will be equities, due to US corporate profit advances driving the Dow Jones and S&P to new all time highs, commodities, which were already oversold due to exaggerated fears about the slow down in China, and the Australian dollar, which benefits both directly from US dollar weakness, and indirectly via commodity price rises. The impact on US corporate profits from a lower US dollar cannot be over emphasised. More than half of the revenue of the top 500 US corporations comes from outside the US.
With the “double positive” impact on the Australian dollar, I continue to expect our local currency to rise back above parity to the USD by the end of the year.
Commodity prices are likely to rise even more quickly, and so our miners should continue to do better than perhaps even their own expectations at this point.
All in all a lower US dollar will continue to help correct the various imbalances in the global economy. The trick is to remember that strong US economic data, is actually US dollar bearish.
Clifford Bennett is chief economist of the White Crane Group at http://www.whitecranegroup.com.au/eureka/