My first book, Making Sense of the Dollar, was published by Bloomberg Press ten years ago this week. It was named a Bronze medal winner by Independent Publishers. It sought to counter the declinists of the period who, understandably, if even mistakenly, thought the dollar was on an exorable path that had been carved by sterling as it lost numeraire status a century earlier. In 2008, as the book was being written, the euro reached a record high near $1.60, and sterling was still trading around $2.00 after peaking in 2007 closer to $2.12. The Dollar Index tested 70.00 in Q2 08, a record low.
Rather than mark the demise of the dollar, the book anticipated a new dollar bull cycle. It was a difficult call then. The manuscript was being written as Lehman failed and the Great Financial Crisis was continuing to unfold, and the European phase of the crisis still lay ahead. It took some time to gain traction, this was the third significant dollar rally since the end of Bretton Woods.
The rallies are obvious on this Bloomberg chart below of the Federal Reserve’s real (adjusted for inflation) broad (inclusive) trade-weighted index. The Reagan-Volcker dollar rally that began a little before Reagan was elected was driven by the tightening of monetary policy and later Reagan’s tax cuts and spending increases. That remains the best policy mix for a country’s currency. Intervention at the Plaza Hotel in September 1985 marked the end of the dollar rally. A ten-year bear market ensued.
Then in the mid-1990s, the second significant dollar rally began. The rally was a combination of the beginning of the tech rally and a shift in US policy. Clinton’s Treasury Secretary Bentsen, like several of his predecessors, used the dollar’s exchange rate to try to extract trade concessions. Rubin replaced Bentsen and announced the “strong dollar policy.” This was important, even though it was sport for many to mock it. It meant that the US would not purposely seek a weak dollar to gain trade advantage or as a way to reduce its debt burden.
In a way that is not peculiar to Americans, but they have raised it to a high art form, what is deemed in its interest is generalized for everyone. After a decade (~1985-1995) of trying to micro-manage the foreign exchange market for advantage, the US not only swore it off but led the G7 and G20 to endorse it. The Clinton-Rubin dollar rally did not exceed the Reagan-Volcker dollar rally high before the Europeans insisted the newly minted euro had fallen too far. It fell from around $1.19 at the start of 1999 to about $0.8250. A coordinated round of intervention took place in October 2000 to sell dollars and buy euros.
Another bear market for the dollar ensued. Sterling and the euro may have bottomed in 2008, and the Federal Reserve’s real broad trade-weighted dollar did not bottom until 2011. What may be considered the Obama-Trump dollar rally was initially sparked by a divergence of monetary policy broadly understood and later fueled by a supportive policy mix (like Reagan-Volcker). This third dollar rally did not surpass the Clinton-Rubin dollar rally. The question is, will it?
Starting a few months ago, we have suggested Obama-Trump dollar rally is over. The Federal Reserve’s real broad trade-weighted dollar index peaked at the end of 2016 a little above 103. Despite the gains in 2018 and earlier this year, it has not risen through 102. It has also lost some momentum. After rising nine months, last year, the Fed’s index has fallen in five of the first seven months of this year.
The US policy mix has become less supportive of the dollar. Fiscal policy is tightening, and perhaps unintended by the tax increase on imports. The Fed has delivered one rate cut and is expected to deliver at least two more this year, judging from the fed funds futures and overnight index swaps. Interest rate differentials seem to move against the dollar is the last phase of its bull market (admittedly a small sample size. The US premium over EMU, the UK, and Japan have been narrowing since last November.
President Trump’s claim that the dollar is over-valued is true but not universally. The OECD estimates that the Swiss franc is more than 18% above its purchasing power parity level. The Norwegian krone is about 12.5% over-valued. The Australian dollar is almost 3% under-valued, but this has been fully recorded in the past three weeks. The Japanese yen is estimated to be a little more than 4% under-valued, which would put the dollar closer to JPY105. The euro is the most undervalued in the OECD major universe by around 21%. Sterling is catching up and is nearly 19% undervalued.
More importantly than where dollar valuation is stretched is where it is not. The IMF’s Article IV review announced before the weekend confirmed what it had indicated a few weeks ago. The Chinese yuan is fairly valued and that it does not see evidence of intervention.
Two scenarios were sketched in Making Sense of the Dollar under which it would lose its place in the world economy and finance. The first was if there was a clearly superior alternative. There isn’t. Each option that has been suggested is fundamentally flawed, like the euro, yuan, gold, bitcoin. Yes, there are examples of alternatives, like in Russia-Chinese trade, or some Indian trade, or the yuan-oil futures contract in Shanghai, but these are rather small, marginal exceptions.
The second scenario that could lead to the demise of the dollar is if the US were to abdicate. This is what many suspect is taking place. The US may have begun down this course gradually since 2001 but appears to have accelerated in the last few years. Previously, the US saw its national interest was in providing a public good to the world economy, the dollar, and dollar funding. The “exorbitant privilege” that is often claimed used to mean that the US fund its borrowings cheaply, but when there are $15 trillion in negative-yielding bonds, including some corporate bonds, this accusation has lost its sting.
In any case, the US has increasingly weaponized access to the dollar-based financial system. It denies the utility to countries and actors its does not approve. At the same time, it has shown less commitment to the international global order that it previously was instrumental in building and defending. It has preferred bilateral talks to multilateral trade agreements. The US is blocking the appointment of appellate judges at the WTO.
It may be too early to conclude that the shift toward economic nationalism from international liberalism is more than an aberration. The Democrats seem to support many of the foreign policy goals of the Trump Administration. These include a more direct confrontation of China, denying Iran nuclear capability, getting North Korea to give up its nuclear weapons, regime change in Venezuela, getting NATO members to make good on their commitments, and opposition to the Nord Stream II pipeline that sends Russian gas to directly to Germany. To the extent they disagree, it is over tactics. The Democrats continue to embrace international liberalism, and it is not clear the extent that Trump has made over the Republican Party. The old Lodge-wing (which opposed the League of Nations after WWI) may not have as firm of a grip as it may appear. Next year’s election will clarify the situation.
Trump has tried talking the dollar down with little perceptible impact. His administration has seriously discussed intervention in the foreign exchange market. Although many observers think that with the dollar rising above CNY7.0 and not weakening much in the face the Fed’s 25 bp rate cut, the risk of intervention is increasing, we suspect the practical issues have not changed, and this strongly argues against such action.
We are not concerned about the limited amount of dollars in the Exchange Stabilization Fund that the Treasury Department can sell. The US modus operandi in intervention has never been trying to overwhelm the market with size. That is something the BOJ has tried to do, with a bout of intervention several years ago, estimated to be about $100 bln in one day. Instead, the US typically relies on finesse and, and like US troops abroad, are more about a signal and tripwire than brute force. We suspect a US operation to sell dollars would have an immediate impact.
The issue is not about selling but buying. With China having been cited as a currency manipulator, the yuan would be the logical candidate, but the currency is not freely convertible, and the US would loathe buying Chinese government bonds, which are used to finance the Belt Road Initiative and the People’s Liberation Army. The IMF denies the US charges, and this underscores the aggressiveness of such US action.
We could be wrong, and US intervention would be unsuccessful in weakening the dollar, and unilateral intervention does not have an inspiring track record. This would be embarrassing and erode US credibility in such matters. If it is successful, what stops another country, say China, from using the pullback in the dollar (and likely rise in US yields) to repurchase Treasuries? The US Treasury figures suggest China has sold about $13 bln of Treasuries in the first five months of the year and liquidating about $61 bln last year.
Some suggest the US could buy the euro or yen, but this would be sending confusing signals and needlessly antagonize Europe and Japan. Despite negative interest rates and a still aggressive asset purchase program that includes corporate bonds and equity ETFs, the yen has strengthened nearly 4.3% against the dollar. It is the strongest major currency this year. The dollar is testing JPY105 having had pushed above JPY109 for the first time in two months at the start of August. The strength of the yen will likely add to the disinflationary forces and act as a headwind on growth in H2, just as the government prepares to raise the sales tax (from 8% to 10% in October). Buying the euro and/or yen would force the US to accept negative yields, meaning that it would pay Europe or Japan to take US savings.
This week also marks the 48 anniversary of the end of Bretton Woods. For many years, there has been romanticism about that gold-dollar regime. There has been an almost constant if low-decibel, intellectual fascination with a possible Bretton Woods II. Ten years ago, it did not seem likely, and it is less so today. Bretton Woods was a classic example of hegemonic stability theory. One country, namely the US, had the bulk of the world’s gold and military power, having used two atom bombs on Japan, It had the will and ability to set the rules of the international monetary order, over objections by Keynes, who, in effect, negotiated on behalf of the debtors. It has neither the power nor will today. Several countries, including China and Russia, continue to accumulate gold and China has established numerous swap lines. At current prices, gold cannot absorb serious diversification of the roughly $6.7 trillion Treasury holdings by foreign central banks. China’s swap lines can be important tactically, and recently Turkey, but this is triage and not a systemic alternative.
While the big dollar rally anticipated by Making Sense of the Dollar is maybe over, the current system in which the greenback remains numeraire remains intact. The strong dollar policy announced by Rubin in 1995 survived a bout of dollar selling intervention by him (against the yen) and his successor (against the euro) and a third bout against the yen (after the earthquake and tsunami in 2011). It survived one administration that tried to ignore, with a vice president claiming a strong dollar was one that was difficult to counterfeit. Whether the greenback’s role survives another decade is not clear. We suspect it will survive but diminished. Stay tuned.