The dollar is hitting all-time lows vs. the euro on almost a daily basis. Even the Japanese yen, long the laggard in the currency world, is starting to catch a bid. Recent comments from Chinese officials about diversifying away from the greenback to "strong currencies" pushed the dollar's descent into overdrive, and seemed to want to drag equity markets with it.
This kind of market action has encouraged familiar warnings from those "bunker monkeys" who link the dollar's decline to dark visions of a disorderly global collapse.
But the U.S. dollar has been depreciating for about five years in pretty much linear fashion and is primarily a structural phenomenon, not a cyclical one. Moreover, even though the U.S. economy is clearly facing headwinds that are, if anything, likely to intensify, the greenback's decline, in and of itself, is not a symptom of U.S. weakness.
Instead, it reflects other countries finding confidence in their own currencies, and weaning themselves of excessive dependence on the dollar as the only international currency for their savings and transactions. In short, across the globe, individuals, companies, central banks and investors are de-dollarizing.
What we are witnessing is the unwinding of an overhang of dollars that has been built up in the global system over the last 60 years. And it could last for quite some time. The good news is that this wouldn't be happening if the global economy weren't in unprecedentedly great shape.
That said, I don't mean to suggest that some of the cyclical arguments commonly mentioned for the dollar's weakness don't carry some weight at certain points in time. Some of them do, but they tend to be grossly overstated, and many of the common reasons cited for the dollar's weakness are merely ex-post facto rationalizations for the price action.
Current Account Deficit
: The U.S. has had a large and growing current account deficit for well over 10 years. If currencies were driven primarily by countries' current account positions, the dollar would have started depreciating long ago. The current-account centric world of the 1970s analytical framework is long gone.
Today's world is dominated by gross capital flows, which have grown much more dramatically over the past 20 years than has international trade. It is these that drive currencies these days. Moreover, there have been countless econometric studies trying to link current account positions and currency movements, but to no avail. Lastly, the U.S. current account deficit has been meaningfully shrinking since the end of 2005, even as the dollar's depreciation accelerated.
Interest Rate Differentials
: This does tend to have a stronger effect on currency rates in a capital-account centric world, but the effects are more pronounced when the differentials are extreme (e.g., the Turkish lira, Brazilian real, South African rand, etc.). In the case of the dollar against the euro -- still the world's most important currency pair -- the U.S. entered the most recent rate-hiking cycle well before the ECB and continued to hike at a more aggressive pace; yet this did nothing to halt -- much less reverse -- the dollar's declining trend.
U.S Recession and Subprime Fears
: Over the past few years, the tables have turned somewhat on the U.S., to where it is now in the position of seeing its GDP supported by strong international growth. True, people typically do like to invest in countries that are growing strongly.
However, if we roll back the clock a few years to when it was the U.S. consumer who was propping up global growth and U.S. GDP was growing robustly, the dollar was depreciating. Put another way, the dollar was in full-blown depreciating mode before the mainstream media ever heard the word "subprime."
Budget Deficit and Contingent Liabilities
: These are serious issues, and it is never good if a country's commitment to a sound, long-term fiscal framework is called into question. But I don't think anyone who takes a hard look at the U.S. budgetary position and the dollar over the years would find any meaningful relationship between the two, even a casual one.
: Americans have been rapidly diversifying away from their "home country bias," investing overseas at an unprecedented pace. This is for sure having a negative effect on the dollar. Steven Jen, global head of currency research at Morgan Stanley, has done a good job framing this issue.
However, investors across the planet are also moving away from their home country biases (think of Japanese retail investors, for example), and much of that money is coming to the U.S. for two main reasons. One, other countries' asset bases are growing faster than their capital markets can accommodate, and/or financial globalization is presenting them with new and exciting options.
Two, the U.S. has the world's deepest and most liquid capital markets, and most global portfolios start with the
and U.S. Treasuries. Thus, it is not clear whether the net flows from the global reduction in home country bias is dollar positive or dollar negative.
It's Structural, Stupid
If it is not cyclical, then what is going on?
Over the second half of the 20th century, the dollar became the undisputed store of value in the international monetary system and the primary medium of exchange/unit of account for international trade. The world held more dollars, and the world transacted more often in dollars. There was really no other choice. Demand outside the U.S. for dollars grew rapidly for many, many years. For monetary balance inside the U.S. to be maintained, the
had to provide these dollars.
Fast forward to today. The world has undergone a radical transformation. Countries across the world are in far better economic shape, their currencies are more stable and increasingly more freely convertible. People trust their own currencies more, as well as the currencies of other countries. Dollar holders -- central banks, sovereign wealth funds, international corporations and individuals alike -- realize they have accumulated too many dollars over the years. Holding such a high percentage of one's precautionary balances in dollars no longer makes sense in today's world. Not because the dollar is bad, but because there are so many opportunities to diversify safely.
Mexicans no longer have to keep as many dollars under the mattress. Brazilian companies no longer need to keep a war chest of dollars hidden in the Cayman Islands in order to ensure access to imported inputs. The Qatari sovereign fund has realized that it is neither wise nor prudent to keep so much of its stock of wealth in one currency. And Italians, Poles, and Turks -- peoples closely linked in one way or another to the euro -- are thinking less and less in dollars (it is amazing that they still do at all).
The transactional demand for dollars is also declining dramatically. This too puts downward pressure on the dollar. In countries like Brazil and India, hotel bills used to be presented in dollars; no more. Cabs in emerging economies used to prefer payment in dollars. Now it's not worth the hassle. Many countries that historically quoted real estate prices in dollars are doing so less and less. Even oil contracts are starting to be inked in currencies other than the dollar. And we know what the super models are doing...
With the demand for dollars structurally falling, the dollar should face headwinds until currency stockpiles have adjusted and a new equilibrium is found. This doesn't mean we can't have vicious countertrend rallies in the dollar. Every time risk aversion gets intense enough, the dollar tends to do exactly this. My guess is that we may well be at such a point right now.
In sum, the dollar likely will be facing structural headwinds for quite some time to come, but it should not be read as a symptom of the demise of the U.S. economy as we know it.
Mr. Dow is a portfolio manager at Pharo Management LLC, a Global Macro hedge fund with an Emerging Markets focus. Prior to joining Pharo, he was a portfolio manager at MFS Investment Management, where he managed a variety of fixed-income funds, with special emphasis on Emerging Markets. Previous to that, he worked as an Economist at the International Monetary Fund and at the US Department of the Treasury.