GDP growth in the world’s major economies has been accelerating, thus generating a narrative of a ‘synchronized global recovery’. In these conditions the US Dollar tends to depreciate: as a funding currency, the Dollar is borrowed to invest in cross-border investment opportunities. This demand brings more and more Dollars into circulation, and chase a relatively small number of international investments. It depreciates in response.
Forward-looking indicators for the Eurozone and Japan, plus China’s debt suggests the major economies look set for a slowdown this year. As these economies slow, borrowers of US Dollars will struggle to repay USD-denominated loans, pushing up the value of the Dollar. At MarketsNow we are still bearish on the US Dollar but will be regularly reviewing this position as we monitor the expected slowdown.
Synchronized Global Recovery
Since 2016 the largest developed markets have delivered accelerating growth. Forward-looking indicators like the market manufacturing PMI in Europe and the Nikkei manufacturing PMI in Japan have indicated growth.
It is expected the US Federal Reserve will raise interest rates three times this year but expectations for monetary policy tightening at other central banks are also driving other currencies higher. Subsequently, on a relative basis, the US Dollar isn’t increasing in value against other currencies like the Yen and Euro.
Speculators are still not at a bearish extreme on net short positions, and only a small proportion of the total outstanding interest is shorting the US Dollar. Although there is a small net short position the Dollar has plenty of room to continue weakening without much resistance.
The US Dollar – As a Liability Currency
As discussed, when there is economic growth US Dollars become cheaply and widely available in offshore lending markets (e.g. the Eurodollar market). As these borrowed Dollars flood the market other financial assets tend to appreciate accordingly.
The size of the Eurodollar (a US Dollar held offshore and thus outside the jurisdiction of the Federal Reserve and other domestic rules such as minimum capital requirements and Federal Deposit Insurance Corporation Costs) market is significantly larger than in 2007. Global banks find it hard to resist the allure of low-cost Dollars. For example, Japan’s top three banks have doubled their non-Yen deposits in the last five years. Danske Bank in Denmark has issued 80% of its bonds since 2015 in Dollars. US Dollar liabilities for non-US banks sit at $9T. The consequence of this could be problematic if and when the next crisis strikes.
The Slowdown in Europe and Asia
Global GDP growth remains positive for now but early economic data in 2018 suggests that the current rate of growth is set to decelerate.
In the Eurozone the political and economic landscape is uncertain. Eurozone manufacturing PMI and German IFO expectations have deteriorated. With this level of uncertainty, economic decline is a real possibility.
Politically a number of countries in the Eurozone are facing uncertainty. In Italy, a party called the Five Star Movement (M5S) won 31% of the vote (the largest in the country) and is heavily Eurosceptic. They want immigration controls and a greater degree of direct democracy. The party also favor a referendum to leave the Eurozone. M5S’s may well resist reforms from Brussels and take on government debt to pursue fiscal stimulus, which could weaken the Euro.
In Germany, the SPD agreed to form a “grand coalition” with the Christian Democratic Union (CDU). This was generally good news for the Eurozone and ended six months of uncertainty in Germany, where the country was without a government. With calls for the SPD to undergo a programmatic reboot and with the far-right Alternative für Deutschland (AfD) the largest opposition party, the government in Germany will be put under pressure. But for now, this is good news for the strength of the Eurozone and will strengthen the Euro.
In the UK the fallout from Brexit still lingers. Although negotiations are ongoing and a transition period is being discussed the outcome for the UK and Europe remains uncertain. With a relatively left-wing opposition ready to step into the void the damage to the UK and subsequently Europe and the Euro could be significant.
In Austria, the People’s party and the Freedom party won 32% and 26% of the vote respectively. Both parties are right-wing and the winning People’s Party, in particular, is tough on migration, easy on taxes and widely Eurosceptic. The Chancellor Sebastian Kurz appointed Heinz-Christian Strache, of the Freedom Party) as his vice-chancellor. One of the coalition’s moves was to bring Austria closer to the Visegrad Group, particularly the Eurosceptic governments of Andrzej Duda in Poland, Viktor Orban in Hungary and Milos Zeman in the Czech Republic. Again risking the strength of the Eurozone and Euro.
In China, forward-looking indicators of growth, including manufacturing and non-manufacturing PMI, suggest a subdued rate of growth. Since 2016 the Chinese economy has been expanding; this occurred after the government launched an economic stimulus programme. Recently, this trend has been reversing and a downturn looks likely. Manufacturing and house price growth both peaked in 2017 but are now decelerating.
Ultimately a deceleration in growth will push up the value of the dollar as global economic conditions become less benign. So whilst the outlook on the dollar remains bearish right now, you can expect an improvement later in 2018 as the market stabilizes.