Aaron Costello
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, we do not think Federal Reserve rate cuts signal a major downturn in the US dollar. While Fed rate hikes have been a key support for the dollar in recent years, additional rate cuts this year (should more occur) will not necessarily weaken the greenback meaningfully. Currencies are driven by relative changes in economic variables (growth, inflation, interest rates, etc.), not absolute changes, and changes in market expectations also play a key role.
The dollar rallied last week following the Fed rate cut, as the Federal Open Market Committee’s mixed messages (with some members voting against rate cuts) forced the market to rethink expectations for additional cuts this year. At the same time, other central banks have also been cutting rates, and the European Central Bank in July signaled it too may cut rates or restart its quantitative easing program as growth slows in Europe. This has sent German bund yields to record lows and negative territory. Interest rates in Australia and New Zealand have also hit record lows and now yield less than US rates for the first time in nearly 20 years. Thus, while US growth has slowed and Treasury yields have fallen, the United States remains, in many ways, the best house in a bad neighborhood, at least in terms of relative interest rates.
Furthermore, the US dollar is a “counter-cyclical” currency that tends to rally amid periods of market stress, including US recessions. If the US or global economic outlook deteriorates such that the Fed is forced to cut rates rapidly, this may counter-intuitively strengthen the US dollar amid a global flight to safety.
Indeed, with US-China trade tensions flaring up again amid the surprise US announcement of 10% tariffs on an additional $300 billion of Chinese goods last week and the Chinese government retaliating by permitting the renminbi exchange rate to weaken beyond 7.0 to the dollar, markets are entering another “risk-off” period. Meanwhile, the risks of a “hard Brexit” have also increased after the election of Boris Johnson in the United Kingdom and political uncertainty may continue to weigh on European currencies.
That said, nothing goes up forever and the US dollar does face two longer-term headwinds—general overvaluation and the widening fiscal and current account deficits. It is unclear if further tariffs on Chinese goods will meaningfully reduce the current account deficit, as US exports to China (and US corporate profits from China) will also be hit and importers will pass on the costs of the tariffs to consumers or shift to other suppliers (e.g., Vietnam). Additionally, a weaker renminbi could offset some of the tariff impact. However, we think the prospects of China facilitating a large devaluation (e.g., greater than 10%) are limited for now, given the risks to Chinese issuers of USD bonds and the elevated capital-flight pressures that would result. While the US Congress recently struck a deal that extends the US debt ceiling for two years (and thus removes the threat of a government shutdown or risk of government default due to the debt ceiling), legislators only achieved this compromise by further increasing government spending even as revenue declines due to the 2018 tax cuts. The “twin deficits” (fiscal and current account) force the United States to attract more and more inflows to support current spending. Yet, an overvalued currency makes US assets more costly for foreign investors to acquire.
Indeed, these headwinds may already be weighing on the dollar; the currency has been range-bound for much of the past two and a half years, failing to reach new highs on a trade-weighted basis since December 2016, despite steadily rising interest rates and the strong returns of US equities. Though we aren’t of the view that the US dollar is poised for a major breakdown in the near term, any breakout to the upside may be limited, and is likely to occur amid market stress.
USD weakness tends to occur when economic growth outside the United States is accelerating and non-US rates are rising relative to US rates. This still isn’t the case today. The next major downturn in the US dollar is likely to occur after the next US recession, when US rates have been slashed and global economic growth begins to recover and investors seek more attractive opportunities elsewhere.
Aaron Costello, Managing Director on Cambridge Associates’ Global Investment Research Team