The severe economic downturn is addressing the issues that for so long were dollar negative, writes
Peter Geikie-Cobb and Paul Thursby of Thames River
Figure 1 plots the fortunes of the dollar on a real exchange traded weighted basis over the last 30 years. This can be divided into three distinct periods. From the peak in early 1985 to the first trough in 1995, the dollar was driven by the perils of the twin deficits, both trade and fiscal, as the currency adjusted by falling nearly 50% to rectify the increasing imbalances in the economy.
The dollar then rallied by some 40% off that low over the next 10 years as global capital flows were directed towards the US in search of the best returns during the dotcom mania. From the beginning of 2002 the dollar resumed its decline to its recent low as debt driven consumption once again created significant imbalances as both total debt and the current account deficit reached record levels.
The severe economic downturn as a result of the credit crisis is fast addressing the issues that for so long were dollar negative. As the US economy moves into recovery and potentially back to sustained trend growth, albeit below levels seen pre-crisis, the shape of the economy is likely to be very different.
Apart from the monetary and fiscal boosts that jump started the recovery, US economic growth is now being driven by strong exports. The current account deficit is falling fast from its peak of 8% of GDP and is likely, ex oil imports, to move back to balance over the next 12 months. This has happened partly because the exchange rate is now very competitive and rhetoric from policymakers around the world is evidence of this.
In the last six months we have seen actual FX intervention by the Swiss and the Mexicans and verbal intervention from the Bank of England, politicians and ECB council members in the eurozone, from South Korea, reluctance to revalue the RMB by China and a 2% tax on foreign capital inflows by Brazil.
All this suggests many parts of the world, including some emerging economies, are feeling the competitive strain of an undervalued dollar. In addition, productivity gains in the US are running at between 6%-7% and unit labour costs remain in negative territory. The engine for US growth going forward is likely to be much less consumption driven as the private sector rebuilds balance sheets following the collapse of the housing market and at a time when wage and income growth remains flat. To summarise, the US imbalances in the economy have turned a corner.
The one negative for this strong dollar view is of course the federal budget deficit. It is a problem, granted, but not significantly more so than most other major economies. We believe the US Treasury market has many more sponsors such as sovereign wealth funds and a rising savings rate domestically, that this becomes an issue two years down the road if not addressed, but not a problem for now.
In the UK, the new government has had to address the fiscal deficit immediately to retain credibility and this could smother the recovery, keeping monetary policy loose and therefore the pound weak for some time. And then there is the euro and the systemic risk surrounding Greece and other peripheral markets at a time when German exports at the core of the eurozone are coming under pressure due to an overvalued euro. All this points to a strong dollar as a result of improving and competitive macro data and as a probable safe haven at a time when the carry trade is entirely funded out of dollars and US investors holdings in overseas assets in mutual funds are at a record level.
A final point supporting this view is our expectation that the US Treasury yield curve is too steep and we anticipate a significant flattening. Figure 2 shows the yield pick up between five and 30 year US Treasuries and illustrates that we are now at a 20-year high.
Short-term interest rate differentials between the US, eurozone, UK and Japan are likely to widen in favour of the US giving the dollar further support. As the markets begin to price in a normalisation of US short rates the curve will flatten, supporting long-dated Treasuries (and specifically long strips) that will price in a benign inflation environment.
Should investors expect a US Treasury Bond rally this summer?
In our view, the answer is yes. Especially at a time when markets have a popular bear scenario penciled in for bonds as a result of high supply and the expected inevitable inflation that is widely predicted.
The developed world has a distinctly deflationary bias. This is not unusual after a financial shock. We expect sustainable changes to corporate and consumer behaviour as a result of the historic collapse in credit availability and the major shock to household balance sheets arising from housing deflation. Corporations will aim for permanently lower breakeven points for their businesses while for consumers the availability of credit is no longer a reliable option. Debt and leverage are history, particularly in a world when the global financial sytem still has only just begun the process of deleveraging. Credit, if available, will in the future be hard to find and expensive. Indeed it is the lack of credit demand evident as the global economy revives that is one of the more striking developments in world markets today. Despite the best efforts of Central Banks, broad money growth remains flat or even contracting, and money velocity is very subdued.
We do expect a gradual recovery in economic activity but the road to full employment will be long and winding. The excess capacity in both labour and production will take time to eradicate. Debt repayment together with fading government stimuli, both in terms of fiscal spend and monetary ease, and more satisfactory inventory positioning will, we feel, produce a developed world environment of low growth with a disinflationary/deflationary bias in the system.
A truly inflationary economic structure will only return if there is a radical and decisive shift away from globalisation where free trade and free capital flows are threatened. However this is more likely to push the world into another financial crisis/depression. Commodity prices would surely crash. Not an inflationary outcome in our view.
What of supply?
Greece and others are clearly insolvent but the serious/big countries are not. Action must clearly be taken to address the fiscal imbalances but there is still time. Investors must look at overall supply in the public and private sectors not just the public. Plunging private sector credit demand and the desire for safer yield and duration will in the face of progressively lower core inflation prevail for now.
Long US Government bond yields are approaching 5% with an extraordinarily steep yield curve in an environment of benign inflation and a dovish Federal Reserve. Our money is on a decent rally in the summer/autumn at a time when risk assets have had a good run and a flight to safety an ongoing probability. It will pay to be nimble but in our view a robust combination of dollar exposure and US long Treasuries continue to give investors protection against setbacks in risk-on carry driven exposures.
Peter Geikie-Cobb and Paul Thursby are managers of the Thames River Global Bond fund
