Patterson: The Dollar's Structural Shift
While the dollar appears increasingly “cheap” on a backward-looking basis, structural changes in the global economy – mainly outside the U.S. - could pull the dollar down further, potentially significantly.
The US remains by far the world’s largest economy, accounting for 27% of global GDP in 2009 (JPMS LLC data). The US dollar, meanwhile, continues to enjoy its place as the most traded currency in the world: The Bank for International Settlements (BIS) latest survey showed that a dollar was used in nearly 87% of all currency transactions as of 2010.
Given this, it's all the more surprising what is happening in currency markets today. Structural, macro-economic changes, especially in emerging-market and commodity-producing countries, are increasingly driving the dollar, rather than the dollar driving everyone else’s currency. We believe this could result in a resetting - lower - for the dollar’s long-term fair value, even though the trade-weighted dollar is already close to its weakest point since the early 1970s. The tail, we believe, is starting to wag the big dog of the currency world.
One of the few rules governing FX markets is that floating currencies revert over a multi-year period around some “mean,” or fair value. Some market-watchers think of fair value in terms of Purchasing Power Parity (PPP), popularized by The Economist's Big Mac index.
Such longer-term FX oscillations are pretty easily explained by economics. When a currency appreciates to a certain point and/or for a sustained length of time, that country’s exports usually get less competitive, becoming a drag on growth. At the same time, the stronger currency helps control inflation pressure. Expectations of slower growth and relatively less inflation risk tend to lead investors to reduce expectations for central bank policy interest rates (the currency’s “yield”). The change in expectations as well as actual growth-inflation dynamics often lead investors to pare back exposure to assets denominated in that currency, which in turn generates FX depreciation, until the now-weak currency reverses the macro tide again.
There is a critical caveat to the concept of currency fair value. Structural changes in underlying economies which impact variables such as terms of trade, inflation or interest rates can raise or lower a currency’s fair value. We believe such a shift may be happening today for the U.S. dollar.
Some might argue that US debt/ GDP ratios at 70%, with nearly $14.4 trillion in debt as of 2010, up from $4.2 trillion only a decade earlier, could be a structural change for the US. We believe these fiscal dynamics merit close attention – large debts and deficits, if sustained, certainly could impact capital flows to the U.S. on a longer-term basis. Further, US policy officials have been unusually silent during these last two years of the dollar’s decline. It may well be that the US is comfortable with a slowly weakening dollar in that it helps growth via exports and limits deflation risks.
"ANOTHER STRUCTURAL CHANGE IS UNDERWAY"
However, we believe that another structural change is already underway, outside the US Growing per-capita income and domestic demand across a number of emerging markets is creating greater, sustained needs for natural resources. Countries like China, India, Indonesia, Brazil, Russia are building more homes, roads, railways, buying more cars and computers, than ever before. Australian Reserve Bank Governor Stevens quantified this structural change in a March speech:
“Since the beginning of 2008, Asia (ex-Japan) has accounted for about 70% of the growth in global GDP (measured on a purchasing power parity basis). It has also accounted for about 70% of the growth in global demand over that period. This compares with a figure of about 30% over the period 2000-2007.”
These structural emerging-market changes, especially in Asia, are contributing to a positive terms of trade shock in commodity-exporting countries. (As a reminder, a country’s terms of trade reflects prices for exported goods relative to import costs; an improving terms of trade would suggest that export prices are rising faster than import costs.)
How does all this play out in currency markets? For commodity currencies, trade flows are clearly supportive. So too are capital flows, tied to commodities but also tied to attractive and rising interest rates. This fundamental backdrop is attracting an increasingly diverse array of investors. Indeed, the IMF’s 2010 fourth-quarter report shows that central banks shied away from key reserve currencies (such as the U.S. dollar, euro and sterling) and instead focused on relatively less liquid currencies (such as the Canadian and Australian dollars). In percentage terms, FX reserves denominated in other currencies rose sharply, to a new high of 5.5% from a previous 4.9%.
While central banks are not yet taking big steps into emerging market currencies, a lot of other investors are. Those investors include Americans, who are selling dollars to increase their EM exposures. At the same time, emerging-market central banks are intervening – in size - to control local FX appreciation. In the first quarter of 2011 alone, JPMS LLC estimated that central banks spent $60 billion intervening, accumulating dollars in the process. With diversification programs in place, generally more than a third of those dollars are then sold to buy other currencies (again, increasingly including AUD and CAD).
Let’s tie this back to the dollar. Low short-term interest rates in the US certainly weigh on the dollar, so a normalization of US monetary policy over the coming years may help remove at least one source of dollar pressure – the dollar dog may regain some control over its tail. However, to the degree emerging markets are structurally changing, we believe capital and trade flows related to those changes could overwhelm the U.S. yield story, and take the trade-weighted dollar to new all-time lows. The main beneficiaries will be the emerging-market currencies themselves, but also the currencies where countries are supplying natural resources and other goods to the emerging markets in question. We could see currencies like the Australian dollar and Canadian dollar stronger than consensus now expects not just for weeks or months, but possibly for years. More importantly, this new world order for key emerging markets risks pulling the “fair value” of the dollar lower – reinforcing the need to strategically diversify away from the U.S. currency.
One caveat: While we believe the dollar’s “fair value” may be resetting lower and the dollar bear trend may persist longer than consensus currently expects, that is not to say that there will not be periods of USD strength along the way, and/or certain currencies that actually weaken against the dollar. It remains important to look for good entry levels on currency investments, especially tactical investments, and not to treat every USD pair the same.
Rebecca Patterson is Managing Director & Chief Markets Strategist for J.P. Morgan Asset Management, Institutional.
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