One Currency To Rule Them All… (and in a crisis bind them)

John Leiper - Head of Portfolio Management - 20th April 2020

As the world’s reserve currency, the US dollar is the go-to currency. It is used to price assets, complete transactions and as a store of value. It provides the US economy with a significant competitive advantage over other countries as it lowers funding costs and can be easily printed to produce more money.

The recent sell-off emerged out of a liquidity crunch because the world is in so much debt. This debt needs to be paid back, even as the economy slows and the underlying revenue needed to do so dries up as economies go into lock-down. As a result, we saw a dramatic dash-for-cash as individuals, families and corporations scrambled for US dollars…leading to a significant appreciation in the currency.


The problem with a stronger US dollar is it tightens financial conditions, making a bad situation worse. As a result, the Fed was forced to act. This comprehensive action dramatically increased the supply of US dollars and this increase in supply should undermine the value of the currency.


This is demonstrated in the chart below which shows the year-on-year percentage change of the US dollar index (in pink) relative to the year-on-year change in US Federal Excess Reserves (in white). The huge stimulus measures we have seen take place over the last month has resulted in the dramatic spike in the white line. Assuming this historic correlation remains true, this points to a devaluation in the value of the US dollar to the magnitude of 25%.

If that sounds like a large number, that’s because it is…

However, when you look back over time, it is an order of magnitude entirely consistent with history.

In fact, the US dollar tends to move in long-term cycles, rising and falling with the economy over time. On average, this cycle seems to be around 17 years.

This is evident in the chart below which shows the 17-year percentage change in the US dollar index. As you can see from the white arcs, and arrows, the US dollar index rises and falls in value with surprising consistency over time.

This cycle analysis is a long-term phenomenon and seems to suggest the US dollar should soon start a weakening trend. 

However, another factor is the availability of US dollars.

It is far easier to access US dollars in the US than it is elsewhere. This is particularly the case for emerging market countries which have issued debt in USD and rely on trade to export goods to the rest of the world in return for dollars.   

This can be seen in the chart below which shows the year-on-year percentage change of the US dollar index (in yellow) relative to a measure for world trade volume (in pink). As you can see there is a close correlation between these variables over time.

The coronavirus-imposed lock-down has reduced global trade dramatically this year (because the right axis is inverted the pink line goes up). In fact, world trade has been falling since the end of 2018, before the onset of the coronavirus. This can be attributed to the breakdown in the multilateral trading system as President Trump replaced the World Trade Organisation’s rules-based system with unilateral tariffs in an effort to assert American dominance.

Lower trade means less availability of US dollars in the pockets of those that need it which in turn bids the value of the US dollar higher. So when trade slows, the US dollar goes up in value.

Where does that leave us?

In the short term, heightened uncertainty over the coronavirus, and the collapse in the global economy and trade is keeping the US dollar strong as investors seek safe-haven securities – the US dollar is still the ‘cleanest dirty shirt’.

The Fed is aware of the systemic risk of a strong US dollar to the global economy and has sought to increase the supply and availability of dollars to avoid a full-blown liquidity crisis. Given the amount of global debt, we may yet see further measures to ensure this remains the case.

These two offsetting forces have left the US dollar in a state of limbo. However, once we are through the crisis, and things return to ‘normal’, we are left with an economy awash with US dollars. At this point the fundamentals will reassert themselves and we expect to see a depreciation in the value of the US dollar.

As mentioned in the opening paragraph, the US dollar is used to price assets, complete transactions and as a store of value. Therefore, a depreciation in the value of the US dollar will have implications for global financial markets and asset allocation decisions.

Asset Allocation

Lessons from the past, notably Germany in the 1930s, tell us that printing money can lead to inflation. If this coincides with the erosion of central bank credibility it can lead to hyper-inflation.

What we have today is very different. But before our very eyes we are seeing both the erosion of central bank liquidity (at the Federal Reserve) and a massive increase in the amount of US dollars in circulation. So at some point in the future, inflation is on the cards.

Therefore, at some point in the future, it makes sense to consider real assets such as commodities.

The chart below shows the correlation between the US dollar index (green LHS) and the S&P Goldman Sachs Commodity Index (blue RHS – axis inverted). Should the US dollar depreciate, then a broad basket of commodities would do well. Indeed, not only are commodities cheaper now than historical correlations suggest they should be, but the relationship is asymmetric meaning for a given depreciation in the US dollar, commodities would rally disproportionately more (as shown by the scale on the two axis).

We would also look to increase our exposure to non-US equities. The chart below shows the US dollar index against equities. The blue line is the ratio of US equities (the S&P 500) versus the MSCI EAFE Index which represents global developed market equities outside of North America. Historical correlations suggest that as the US dollar gains in value, US equities outperform the rest of the world and vice-versa. Therefore, our longer term forecast for US dollar weakness implies the record outperformance of US equities since the Great Financial Crisis in 2008 could be coming to an end.

Finally, the longer-term outlook is bearish developed market bonds as the huge increase in fiscal spending results in higher bond issuance and higher bond yields. 

The chart below shows the 10-year US Treasury yield since 1987 and points to higher yields going forward.

Final Thoughts

The above narrative is conditional on the successful navigation of the coronavirus and resulting reassertion of underlying fundamentals.

That remains our base case. Indeed, it is reassuring to see that parts of Europe are taking steps towards re-opening. Austria has proven particularly resilient in its fight against the coronavirus and this week the country re-opened smaller shops including hardware and gardening stores. From the 1st May shopping centres and larger stores will be allowed to re-open and from mid-May they plan to open restaurants and hotels. In all instances wearing face masks is mandatory.

In Germany, plans have been announced to allow stores up to 8,600 sq ft to reopen, including car dealerships (Mercedes-Benz will open factories next week and BMW will do so in May).

We’ve also had positive news on a potential vaccine. Last week there were reports of success in clinical trials for the antiviral medicine Remdesivir. As a result, Gilead’s share price surged over 11% in after-hours trading. Never underestimate human ingenuity. Watch this space…

John Leiper – Head of Portfolio Management

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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