When living in Europe in the mid-1980s (when the dollar was very strong), I asked a currency trader what he expected the dollar to do. He answered that it would “fluctuate.” Although the dollar is not as strong as it was back then, the trader’s short-term forecast remains valid in today’s complex global market place.
One would expect that a currency’s value would be determined mainly by its foreign trade and current account balances. The current account is the difference between exports and imports plus net investment income. It also equals net savings by households, businesses and the government and net investment. When a country runs trade and current account deficits, its currency should fall to make its exports cheaper and its imports more expensive. If exports then go up and imports down, the trade deficit should disappear. With assets priced more attractively, foreign investment should close the current account deficit.
However, the U.S. has run a trade and current account deficit almost every year since the end of World War II. Chronic deficits have not depressed the dollar. Why? The dollar has become a “safe haven” currency. During times of turbulence and uncertainty, investors seek the security of the deep markets found in the U.S. Japan has also become a safe haven in recent years, to the frustration of that country’s leadership, who would like to return to the high powered export model that worked so well for them in the 1980s.
According to the Bank for International Settlements, 44% of international transactions are in U.S. dollars. Dollars are required to finance world trade well beyond U.S. imports, exports and capital flows. The U.S. must run a chronic current account deficit to fund world trade and finance. Having the world’s reserve currency is somewhat of a curse. It is called the Triffin paradox. Robert Triffin identified the conflict between the natural desire to run a balanced trade and current account and the need of the world for the U.S. to run deficits. And, naturally, countries keep a good portion of their reserves in dollars, too. According to the International Monetary Fund (IMF), approximately two thirds of other countries’ reserves are held in dollars as are 62% of their cross-border debts.
Since the Great Recession, the picture has been further complicated by central bank activity around the world. Almost $13 trillion in government securities now trade at negative yields. Some of that is due to central banks, such as the European Central Bank and the Bank of Japan, buying sovereign debt to spur lending, but also to institutional investors looking, not for yield, but for capital gains. Through the end of August, the 10-year Japanese government bond has dropped by 0.33% this year to -0.06%, resulting in a total return of 1.5%. Likewise, the German bund’s yield has declined from 0.63% to - 0.07%, a return of 7%.
The euro is under stress, not only because of weak economies, but because of Brexit and the potential desire of other countries to leave the union, voluntarily or otherwise.
Chinese leaders worked diligently to have the prestige of having the yuan recognized as a reserve currency. Now that the IMF has included them in the club, they are now back to manipulating their currency. They are in the difficult position, though, of not wanting to look like they are depressing their currency and losing international credibility. Nor do they want to encourage capital flight. Chinese foreign currency reserves have already dropped $800 billion from their peak of $4 trillion.
What does this mean to those of us who invest? We are inclined to believe that the dollar will remain relatively strong and will likely increase in value. Long dated interest rates will be subdued and may decline further. And, as deflationary forces work their way through the economy, industrial commodities including oil may also continue to be under pressure. With global growth slowing and corporate earnings struggling, we expect to see higher volatility in equity markets.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- All performance is historical and is no guarantee of future results.
- Data provided the Bank for International Settlements, Gary Shilling, and Bloomberg.
- All indices are unmanaged and may not be invested into directly.
- All investing involves risk including loss of principal.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Bond yields are subject to change.
- International investing involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk, and risk associated with varying settlement standards.