Merlin Weekly Macro: Dollar deliberations

Only someone who has been cryogenically frozen or is alone on a deserted island with no mobile phone could not be aware of the seismic ripples pulsing through the world’s geo-political, economic and financial systems. Contrary to popular opinion, Donald Trump is not the sole cause. But he has undoubtedly been the catalyst that has significantly accelerated the reaction, the reshaping of the world order, and added to the uncertainty of the outcome. What we are experiencing is not some creationist Big Bang event; it is a dynamic but evolutionary process with the added twist of a large novel experiment tossed in with an unpredictable result. The only near-certainty is that Trump having prised open the lid of Pandora’s economic box and released the furies, getting them all back safely inside and subdued, the restoration of the status quo ante, is not going to happen. It is therefore unwise in such circumstances to pin hopes on what you expect (i.e. want) a rational outcome to be; circumstances may determine a very different result, even one that appears completely irrational.

Rational investors are clutching at straws: the recent significant volatility in equity and bond prices is ample evidence. Conventional anchor points have come adrift. With Trump apparently either deliberately or absent-mindedly firing off random and often contradictory policies, or as was the case a week ago, launching a bad-tempered tirade against the Chairman of the Federal Reserve over monetary policy, markets are jumpy. They are reacting to every shred of evidence that supports either a restoration of orderliness, or the other way, suggestions of a new as yet untapped seam of instability.

As we go to press, smoke signals are emanating from the White House of Trump’s willingness to de-escalate the tariff war with China. Earlier in April it was the bond market reaction and the big hike in government borrowing costs which caused him to have second thoughts about the wisdom of his ‘Liberation Day’ pronouncement and its punitive rates of duty, and to dial down the vitriol. His latest blink seems to be the evidence of Sino-American trade flows drying up, the Port of Los Angeles becoming eerily idle and growing tumble weed, and the boss of Walmart protesting that his shelves, usually stocked with cheap Chinese manufactured goods, are emptying fast with no signs of replenishment. China is so far playing hard-ball but with hints of concessions. The situation is developing.

Today’s asset behaviour: understanding the past

In febrile times, strange things happen in the investment world. Such has been evident recently. Allow us to jump back in time: follow the trail and all will be revealed.

Back in the Days of Yore, before the invention of quantitative easing (QE) as a response to the systemic risk posed by the 2007-10 Global Financial Crisis, conventional investment wisdom used to be that if equity prices were strong, bond prices were weak and vice versa. They were a natural hedge for each other in a ‘balanced’ portfolio. QE put paid to that: central banks adding stimulatory liquidity by buying their own government’s bonds in the market drove prices up and yields down and suppressed interest rates. A direct consequence was that subsequent bond auctions from treasury departments would inevitably carry a lower nominal coupon (rate of interest). As cash income streams from government bonds diminished and the bonds simultaneously became more expensive, so investors (principally the life insurance companies and the pension funds, both of which need significant ready-cash resources to fund their immediate liabilities paying pensions and paying out policies) looked for other sources of dependable cash income.

Dividends from what were regarded as predictable and stable equities (e.g. utilities, food producers, tobacco companies etc) were identified as an alternative source, known colloquially and inaccurately as the ‘bond proxies’. Excess demand for such shares had the inevitable effect: prices up, yields down. So, on to the next. Property and attractive rental streams, with the same result: higher prices and lower yields (and a liquidity trap given how much more difficult it is to sell a property than an equity or a government bond). You see the pattern.

As QE remained a staple policy of all the main central banks for a prolonged period after the GFC (especially in Europe where from 2015 the policy was explicitly designed to stimulate economic growth rather than address a systemic risk in the financial framework), gradually the main asset classes correlated positively: all their prices rose together, the natural investment hedge was broken. In the case of bonds, peak irrational behaviour was reached when bond yields went negative in 2019 and remained so for three years until interest rates rose sharply thanks to the inflation risk from the pandemic and Putin’s invasion of Ukraine: lenders were paying governments to borrow money rather than demanding traditional compensation for credit and term risk (invoking the Law of the Greater Fool which says that it is a fool’s errand to buy something that is already known to be overvalued; it requires someone even more foolish to buy it from you at even greater expense so that you avoid incurring a loss). At one point, a third of all government bonds globally were on a negative yield; in a case of déjà vu, this week, the Swiss 2-Year government bond yield has gone negative again.

Counterintuitive correlations

Why is this history lesson relevant today? One of the effects of recent topsy-turvy US trade policy and the investment reaction to it has been an added unusual dimension to the correlation of assets behaviour. In the past few weeks of turmoil in the US, we have seen the reverse slope of the positive correlations described above: amid the volatility, generally weak US equity prices and weak US bond prices (the effect of higher yields on the expectation of the inflationary effect of the tariff regime). But there has been a twist: the dollar has been weak too. This is less usual. It is counterintuitive.

High bond yields (especially today in the US relative to other competitors with lower nominal levels, though not the UK) are the inference of the anticipation of interest rates being higher for longer; a high differential interest rate tends to attract investors to that country’s currency, driving the value up. In America’s case it has had the opposite effect and driven it down. The dollar has lost 10% of its value against a basket of international currencies since mid-January (DXY, the dollar basket index has declined from 109.9 to 99.4; the corollary for the UK is that sterling has appreciated against the dollar from $1.21, to $1.33 despite a weaker UK economy).

Normally in times of stress, investors ‘fly to safe haven’ assets, ones where they perceive their capital has greater protection. Dollar assets often head the list: the US is the world’s biggest economy, it has a history of relative robustness, the dollar is the world’s principal reserve currency and there is a natural expectation that in the event the wheels fall off, the Federal Reserve will be the global financial Thunderbird, the International Rescue organisation that restores order from chaos. That investors have shunned US treasuries and the dollar spells out the implication of markets’ concerns that the US itself is the problem: 1) the US cannot be a safe haven while its president is the rainmaker of so much global instability; 2) his strategy, such as it is, might fail and leave the US worse off, potentially strategically and economically isolated, and 3) publicly rubbishing the Chairman of the Federal Reserve by Tweet as a ‘loser’ and by implication undermining the authority of the central bank might appeal to the populist anti ‘Washington swamp’ constituency but it is not what is expected of the Head of State (that Trump later recanted and that he won’t sack Jerome Powell is not the point: he has left markets in no doubt that he has no confidence in the Federal Reserve and resents its independence).

Understanding the dollar

Speculation is starting to mount that the dollar’s supremacy as ‘the’ reserve currency is at least under threat, if not over. We will come to that in due course. But first, let us address the dollar’s value. There is absolute logic in Trump wishing a weaker dollar and its knock-on effect on prices: from a trade standpoint it makes US imports less attractive and America’s exports more competitive. This is entirely in keeping with what Trump is trying to do with tariffs: reduce the proportion of goods imported, onshoring US manufacturing and boosting US jobs, and seeking to export greater volumes of goods to foreign counterparties. His calculation is that for the consumer, the price effect of a lower dollar potentially being inflationary is more than offset by the reduced costs of debt financing, whether for mortgages, car purchases, credit card bills and domestic loans (the catch is that many of these financing products are directly priced off prevailing bond yields rather than the central bank interest rate). He sees a direct cause of what he considers an overvalued dollar to be the unaffordable premium associated with that ‘safe haven’ status and reserve currency leadership. The usual pressure valve in the balance of payments is the exchange rate; if the currency’s natural value is being overridden and placed at a premium by exogenous intangible factors that have nothing to do with trade, then ‘talking down’ the dollar is entirely logical.

This thesis is no idle speculation: it is all clearly laid out in an extensive research document published by Hudson Bay Capital in November last year, titled “A User’s Guide to Restructuring the Global Trading System”; Chapter 2, ‘Theoretical Underpinnings’ has the subheading, ‘The Roots of Economic Discontent Lie in the Dollar’.  The author, Stephen Miran, was a former Hudson Bay Senior Strategist; he is Chair of the Council of Economic Advisers and much more importantly, he is Trump’s senior economic adviser. Trump’s strategy, albeit in a uniquely random Trumpian way, is otherwise playing out a-b-c by the Miran script.

The future: be careful what you wish for

Let us wrap up on the strategic debate about the dollar hegemon. The US Administration has a paradoxical attitude to the dollar: it enjoys the supremacy of the geopolitical and geoeconomic leverage that the dollar confers; it underpins the global settlements for trade and commodities (notably oil); it provides the foundation for the global financial system thanks to the depth of the pool of capital available from a single economy which accounts for a quarter of the world’s GDP; many of the world’s economies particularly in Latin America and Asia have their currencies pegged to the dollar for stability. It is no coincidence that organisations such as the International Monetary Fund, the World Bank and the United Nations are all headquartered in the US. On the other hand, the dollar’s pre-eminent position can periodically (as deemed today by Trump) be considered overvalued from a domestic perspective, as a result creating economic headwinds for the US economy. While politics and the economy are inextricably linked, there is a natural political-economic tension with the dollar.

The fact is that the dollar hegemon is eroding gradually over time anyway. According to IMF data, in 2000, it accounted for over 70% of total global currency reserves; a year ago, the IMF reported the dollar accounting for 59% (followed by the euro at 20%, the yen for 6%, sterling 5%, the Canadian dollar 3%, Australia’s dollar 2% and the Chinese renminbi also 2%). It still dwarfs everything else but as the IMF reports, the dollar’s reduced role is less a function of significant increases in the share of other major currencies than it is the use of the currencies of countries such as China, Canada, Australia and South Korea which have become more common: “These non-traditional reserve currencies are attractive to reserve managers because they provide diversification and relatively attractive yields, and because they have become increasingly easy to buy, sell and hold with the development of new digital financial technologies”.

However, as we have discussed in these columns on many occasions including last week, in the geopolitical powerplay that is actively at work, countries such as China, Russia and Saudi have been working deliberately to disintermediate the dollar, particularly in the settlement of oil contracts; it is part of China’s New World Order strategy for global dominance over the next quarter of a century. Whether it works or not depends on who is complicit and who is resistant; America is resistant.

But for those who believe that actively breaking the dollar (and therefore the US) hegemon is a good idea, consider the alternatives (because something would replace it, indeed would almost certainly have to in order to maintain confidence and stability in global financial, economic and settlement systems). They would be among the four other currencies (euro, renminbi, yen and the pound) officially recognised by the IMF as designated members of the Special Drawing Rights group:

The euro? Clearly it is a major currency, second only to the dollar in its reach and importance. But its foundations are built on sand: it is a half-baked confection of an economic ‘system’ that has no homogeneity to it. Monetary union is incomplete (7 countries in the EU remain outside the eurozone); there is no complementary fiscal union to match monetary union even in the eurozone; the prerequisite of fiscal union is political union the chances of which in the foreseeable future are zero; and there is no debt union to underwrite financial risk among its members. Nobody inventing an economic system from scratch would create the EU’s structure as it is configured today. Over 35 years the EU (as currently constituted) has surrendered 10 percentage points share of global GDP and is in relative decline. As the world’s pre-eminent reserve currency to replace the dollar, logically and rationally it is a non-starter.

The renminbi: much the newest member, China joined the SDR club in 2016. With its stated plan for global dominance it has every ambition of it seeing the renminbi supersede the dollar. China is rated by American and British intelligence agencies as the principal threat to western security (others, but not all in the western alliance, agree with the US and the UK, and among those who do there are nuances about the priority of the threat and many hold widely differing opinions about how to address it). The question is simple: in breaking the dollar, is the aim to facilitate and accelerate a Chinese Communist New World Order based on Socialism with Chinese characteristics  with its implied neo-colonialism and fealty to Beijing? Think carefully before answering.

The yen and sterling? Their heyday is long past; neither economy is big enough to create a global centre of gravity; Japan’s government is laden with debt (255% of GDP); the Office of Budget Responsibility projects the UK as effectively bankrupt within 30 years.

As for alternatives, there is much talk of crypto currencies taking the lead. It is pie-in-the-sky thinking until they become widely accepted means of exchange; and without a recognised issuing authority with regulatory powers to bring credibility, a crypto-based regime is the chaos-merchant’s dream and the antithesis of good order. Gold too is a non-starter; its current price strength reflects the enduring characteristic of the precious shiny metal as a store of value in unstable times combined with its rarity. It is that rarity which precludes it in the 21^st Century economic system. The Gold Standard broke down in WW1, simply because there was insufficient physical gold bullion to cover central bank reserves when countries urgently needed cash to fund their war efforts. Its eventual successor, the Bretton Woods agreement after WW2, pegged currencies to the dollar and it was the dollar which was fixed to the gold price at $35 per ounce (in a neat twist today’s gold price is within a whisker of being exactly 100 times that value). By the 1960s, the expansion in the global economy and the significant issuance of dollars to support it outstripped the supply of gold. It left the US both unable to cover the potential liability from gold reserves, and it created an overvalued currency (today, less than 5% of the value of gold traded is represented by hard metal; the rest is paper derivatives and swaps). The system of pegged exchange rates had outlived burgeoning global growth and domestic US expenditure. The eventual collapse of Bretton Woods in the 1970s paved the way for today’s entirely fiat systems with floating exchange rates.

It is often said that you can only consider the future through understanding the past. We are living through extraordinary times. Opinions are sharply divided as to whether Trump is a genius or whether the lunatics are in charge of the asylum. But as was the case with Putin and his invasion of Ukraine, the smart strategist tries at least to understand where such rainmakers are coming from before dismissing them as irrational.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.