US growth and bond yields have converged towards those of the rest of the world this year. But there has been no reversal of the US dollar’s 2018 strength, merely a slowing of its appreciation.
For decades, the most consistent driver of the dollar has been the difference in growth between the US and the rest of the world. This simple yet powerful model has limits, however. In particular, it breaks down when global growth is weak.
An environment in which the US grows at 3 per cent and the rest of the world at 5 per cent is not the same for the dollar as one in which the US grows at 1.5 per cent and the rest of the world at 3.5 per cent. Faced with weak growth in the rest of the world, investors gravitate to US bonds and defensive equities, and the dollar strengthens.
According to our models, we were right at the threshold for this model early in the second quarter, when global growth was running at roughly 3.2 per cent a year. Then, the trade war restarted.
The dollar’s resilience has caused considerable frustration and venting in the Trump administration. Despite the pressure it is under, not because of it, the Federal Reserve may deliver so-called “insurance cuts” to interest rates. But it would cut more aggressively than the 0.9 percentage points already priced for the next 18 months only if economic and asset volatility were to rise significantly.
The dollar benefits as a safe haven in this setting.
If the Fed cannot weaken the dollar, the Treasury may be directed to take matters into its own hands; unilateral intervention cannot be ruled out. This may be effective in the short term but the main impact of an explicit currency war will be to torpedo an already fragile international trading system. Ironically, the resulting hit to the global economy may lead to a stronger dollar over the medium term.
Sustainable dollar downside requires two things: stronger global growth and an erosion of the US’s yield advantage over G10 currencies. This can happen only when growth in the rest of the world is strong enough to push yields materially higher there. To assess this possibility our attention must turn to the main driver of global growth — China.
Since the 2008 financial crisis, there have been three global growth cycles, beginning in 2010, 2013 and 2016. Each of these was preceded by Beijing orchestrating a big credit boom, and as these cycles matured, the dollar was rendered much weaker than at other times. After tightening monetary policy last year, Chinese authorities have once again opened the spigots, adding credit equivalent to nearly 8.5 per cent of gross domestic product in just the first quarter of 2019. It would appear, then, that things are shaping up for a serious dollar downturn in the months ahead. But that conclusion may be premature.
China’s credit cycle may not continue at the same pace for long as it is now both less willing and less able to boost the economy aggressively. Chinese policymakers have reiterated that their intention in adding liquidity early in 2019 was to stabilise, not stimulate, the economy. Other than creating further imbalances, much more stimulus could also put pressure on the renminbi. China’s domestic money supply of about $28tn stacks up high against $3.1tn in its foreign exchange reserves. If expectations of currency depreciation become entrenched, even a small proportion of domestic money looking for an exit can put pressure on reserves.
The texture of China’s stimulus is also changing in a manner that makes it less impactful on the rest of the world. Previous rounds of stimulus have been directed largely at the housing market and state-owned industrial groups, the most import-thirsty parts of the economy. Investment in these sectors affected growth positively across Australia, Europe and Brazil, among others.
In contrast, the current round of Chinese stimulus is directed at the low-income consumer and infrastructure spending in urban services: sectors which make far fewer demands beyond China’s shores. If global spillovers from Chinese growth are structurally declining, as we believe they are, then US assets, which are less sensitive to the global cycle than European or emerging markets assets, will see an increased allocation in investor portfolios, keeping the dollar well supported.
The US Treasury or the Fed cannot mark the dollar at a specific level by themselves. It is an outcome of several variables, the most important of which is growth in the rest of the world. As long as this struggles to find its feet, the dollar will remain firm.
Bhanu Baweja is chief cross-asset strategist at UBS Investment Bank