During the last three years the US dollar has appreciated by over 25% against major currencies (see Exhibit 1 below). This rally has been driven by a series of events. These include the announcement, by the Bank of Japan (BoJ) in July 2014 of an extension to its quantitative easing (QE) programme, the prospect of the US Federal Reserve (the Fed) embarking on a new cycle of hikes in official rates in an environment of falling commodities prices and a devaluation of the Chinese yuan in August 2015.
Exhibit 1: The US dollar (here we show the US dollar on a trade-weighted basis against the currencies of America’s trade partners) has undergone a significant rally in recent years (graph shows changes in the US dollar index (DXY) over the last five years).
Source: BNP Paribas Investment Partners, Bloomberg as of 10 February 2017
Is the US dollar at the start of a bullish trend that could endure for several years?
To answer this question, we have opted to limit our analysis to three factors which we consider essential in assessing the prospects for the US dollar. Firstly, we shall review the two previous major US dollar bull-trends during the 1980s and 1990s, and then examine the economic forces in play and the relationship with commodities.
In the following analysis, we shall frequently refer to the DXY dollar index, which is a measure of the value of the US dollar relative to a basket of the major trading partners of the United States.
The dollar enjoys a unique status as the world’s ‘reserve currency’ (an “exorbitant privilege”, to use the term coined in the 1960s by Valéry Giscard d’Estaing, then French Minister of Finance). As American economist Barry Eichengreen observed: ”It costs only a few cents for the Bureau of Engraving and Printing to produce a USD 100 bill, but other countries have to pony up USD 100 of actual goods in order to obtain one.”
Accordingly, the dollar is a currency held by a large number of governments and institutions to ensure payment of their international debt.
On 18 August 1971, President Nixon unilaterally suspended the convertibility of the US dollar into gold (the ‘Nixon Shock’), which resulted in the US dollar fluctuating freely against other currencies. Nixon’s decision did not formally abolish the Bretton Woods system of international finance that had been created in 1944 to “ensure exchange rate stability, prevent competitive devaluations and promote economic growth.” However, Nixon’s decision to suspend one of its key components effectively rendered the Bretton Woods system inoperative.
Since 1973, when the Bretton Woods system was de facto replaced by a regime based on free floating fiat currencies, there have been two major US dollar bull runs – 1980 – 1985 and 1995 – 2002. Year-on-year performance analysis demonstrates a degree of regularity. Although the fluctuations recorded were not of the same magnitude, the US dollar index seems to follow a 15-year cycle (see Exhibit 2) and appears to be set on an upward trend until 2019.
Exhibit 2: The US dollar index (DXY) seems to follow a 15-year cycle and may be on an upward trend until 2019
Source: Bloomberg, as of December 2016
What major events influenced the US dollar’s value during the 1980s and 1990s?
In the early 1980s, many Latin American developing economies took advantage of ample US dollar liquidity in the form of their oil revenues (so called ‘petrodollars‘) to finance lavish infrastructure projects. The resulting budget deficits were financed via credit in the form of floating-rate, short-term loans denominated in US dollars.
When, in 1979, under Paul Volcker (the ‘Volcker shock’) the Fed decided to raise interest rates sharply, these economies’ dollar-denominated debt burdens suddenly increased. In 1982, Mexico was the first of many Latin American countries to default on its sovereign debt (in what became known as the Mexican debt crisis). Mexico announced, in August 1982, that it was unable to service its external debt of USD 80 billion causing a contraction in US dollar-denominated credit. Local currencies collapsed (between August and December 1982 the Mexican peso lost 50% of its value against the US dollar). Panic buying by investors drove the dollar higher. Between 1980 and 1985, the DXY index rose by 95%.
The Asian financial crisis that began in 1997 in Thailand raised fears of a worldwide economic meltdown due to financial contagion. During the mid-1990s, newly and only partially deregulated banks in Southeast Asia started borrowing heavily in US dollars (many of the Asian currencies were pegged to the USD, which was rising in value). Heavy inflows of foreign capital created a speculative bubble in property prices and the stock market. At the time, anchoring local currencies to the US dollar was perceived as an ‘exchange rate guarantee’. Asian banks borrowed through short-term loans, essentially in US dollars, to make long-term loans in local currencies. When in 1997, Asian exports began to slow and local property markets trembled, foreign capital was abruptly withdrawn. This triggered a major crisis with a vicious circle of capital flight pushing down Asian currencies versus the US dollar and stoking further outflows of capital. Central banks in the region were forced to un-peg their currencies from the US dollar. The extent of the damage was catastrophic – far worse than the consequences of the Great Financial Crisis (GFC) in the West in 2008. The Thai baht and South Korean won lost 50% of their value, while the Indonesian rupiah fell by 80%. In per capita terms most of Southeast Asia was still poorer in 2005 than in 1998. Between 1995 and 2002, the DXY index gained 51% (see Exhibit 3).
Exhibit 3: The graph shows changes in the exchange rate of the US dollar on a trade-weighted basis (the DXY (DXY) index) between February 1967 and February 2017 and indicates some of the major events that influenced the exchange rate of the US dollar over this time
Source: Bloomberg, as of 10 February 2017
During both of these crises, massive debt burdens were accumulated in US dollars and then used to finance spending in local currencies on account of what seemed at the time to be an exceptionally favourable environment. An ensuing event then led investors to repatriate their dollar assets triggered a major crisis.
Are we in a similar situation today?
According to the Bank for International Settlements, carry trades represented over USD 8 trillion at the end of 2014 (see Exhibit 4 below). Carry trades involve borrowing in US dollars which are then converted into currencies with high interest rates. The monetary policy adopted by the Fed based on sustainably low rates has enabled the amount of carry trades to build up, including 75% in emerging currencies. The total amount of outstanding loans is somewhat comparable to the situation which led to the crises referred to above. A sudden unwinding of these carry trades would drive the dollar sharply higher.
Exhibit 4: US dollar credit to non-banks outside the United States
Source: Bank for International Settlements as of December 2016
Do current economic indicators imply that the US dollar rally will continue?
Between 2009 and 2014, the Fed implemented a quantitative easing (bond-buying) programme which added over USD 3 trillion to the Fed’s balance sheet.
In December 2015, the Fed hiked official rates for the first time since June 2006. The Fed followed through with a second rate hike in late 2016.
In parallel, the ECB and the BoJ are currently pursuing accommodative monetary policies creating over EUR 960 billion and JPY 80 trillion per year.
These three central banks, whose currencies, according to Swift, represent 75% of international payments, are implementing divergent monetary policies. Supply in euros and yen is increasing, but that of the US dollar is decreasing. Although a classic price adjustment due to supply-demand dynamics should therefore force the US dollar higher against the euro and the yen, predicting the final outcome is not so simple.
Exchange rate mechanisms are complex and depend on the relative positioning of numerous indicators, including inflation divergence, interest-rate spreads and the balance of payments.
The classic ‘purchasing power parity’ theory considers that inflation rate divergence is a major determining factor impacting spot exchange rates. Steeper price increases in the US should drive the US dollar lower against the euro and the yen. Until 2015, the US dollar index was negatively correlated to variations in the US consumer price index (CPI) (see Exhibit 5). However, the prospect of rate hikes from the Fed seems to be fuelling demand for US dollars (interest rate parity theory) and limiting the effects of higher inflation. Since March 2015, the US dollar index seems to have lost momentum and has remained in the 92 – 100 trading corridor.
Exhibit 5: Until 2015, the US dollar index (DXY) was negatively correlated to variations in the US CPI. The graph shows the DXY vs. the CPI between October 2003 and April 2016
Source: Bloomberg, as of December 2016
Commodities have also fluctuated sharply over recent years along with the dollar. What is the link between the dollar and commodities?
Between 2014 and 2015, the price of crude oil fell by 66% from USD 110.8 to USD 37.3 while the DXY index rose by 23% (see Exhibits 6 and 7 below). The slowdown in Chinese growth led to a fall in demand for commodities (oil and copper) whereas the oil and gas supply rose as hydraulic fracturing developed in the US. This industry is continually improving its efficiency, with the breakeven threshold falling from USD 67 per barrel in 2013 to USD 29 per barrel in 2016. The fall in demand on the one hand, and increased supply from new sources on the other, both occurred against a backdrop of already high production output from the OPEC countries. In this context, commodities prices were bound to fall.
Exhibit 6: Changes in oil prices between December 2011 and December 2016 relative to trade-weighted US dollar index (DXY) on an inverted basis (as oil prices fell the US dollar index rose)
Exhibit 7: The’vicious circle’ of falling commodity prices, lower revenues for commidity producers and a stronger US dollar (the graph shows changes in commodity prices (Bloomberg commodity index) relative to the US dollar index (DXY) on an inverted basis for the period between December 2011 and December 2016
The downward trend in commodities prices had secondary effects, however. As oil prices fell, producer countries saw a decline in their revenues in US dollars (see Exhibit 6 above). More specifically, to absorb a 50% fall in the price of crude, producer countries have had to double their output to achieve budgetary equilibrium expressed in US dollars. Such an increase is hard to attain – global production has been at its maximum level of 33.39 million barrels/day since 2008. The strong correlation between the oil price and the commodities index (Bloomberg BCOMXAL index) seems to confirm the ‘vicious circle’ of falling prices, lower revenues and a stronger US dollar (see Exhibit 7 above).
The 25% increase in the dollar (DXY) since 2014 appears minor compared to the 51% and 95% rallies staged during the 1980s and 1990s respectively. Any acceleration in the pedestrian rate of the Fed’s current rate-hiking cycle could provoke a disorderly unwinding of USD 8 trillion in carry trades, while a further fall in commodities prices could trigger a ‘vicious circle’ of falling commodity prices and a rallying US dollar. Consequently, the bullish US dollar trend seems destined to continue and harbours significant further upside potential.