‘Policy Divergence’ Consensus
Today “policy divergence” is the buzz. Global central banks will soon be traveling very different monetary pathways from the Fed. The consensus-held corollary is that higher interest rates will push the dollar to loftier heights.
If only it were that simple. Interest rate differentials are hardly the only factor driving currency returns. In fact, once upon a time, higher rates were viewed as a negative for currencies—an indication that the country was forced to pay higher funding costs because of inflation or other some other illness of the currency.
What’s more, history disagrees with the consensus here. The last two episodes of Fed tightening (starting in February 1994 and June 2004) actually produced a weak dollar in the following six-month period, staying suppressed for the following three years.
What other factors are important at this juncture? Consider at least four big ones, all suggesting a weakening U.S. dollar directly ahead:
1. “Escape velocity” may be elusive, but the post-crisis climate is fading. One of the primary contributors to a rising U.S. dollar has been an economy saddled with high debt. By definition, high indebtedness is deflationary. As households deleverage, less credit means less supply of currency in circulation, and therefore a strong dollar.
Yet we are now quickly approaching an inflection point. On a world scale, the U.S. has arguably most successfully deleveraged. Household debt has fallen to its lowest point relative to incomes in more than a decade. Credit growth is also expanding. Excess capacity is no longer an issue. And encouragingly, incomes are finally picking up. These are not the conditions for a disinflationary backdrop or a strong dollar. A weaker-than-expected U.S. dollar would have enormous investment implications, not least for emerging markets, where a strong dollar has contributed to widespread credit crunch fears and slumping stock markets.
2. “Policy convergence.” To be sure, global central bankers no longer perceive American-style post-crisis policies as avant garde. Whether or not we agree with these approaches, they are now standard operating procedure. The U.S. economy has become a leading indicator of what other central banks will do. In fact, the more the U.S. moves away from stall speed, the more pressure will be on other central banks to “converge” and do more so they, too, will be successful like America.
The above may explain the euro’s recent stability. On the surface, recent news from the ECB (notably, intensifying its QE program to unprecedented levels) should have produced a weaker euro. That has not been the case. What’s happening? Very likely, capital is rewarding the best macro stories—nations with ongoing ultra-stimulative monetary policy and growth moving in the right direction. Combine that with equity valuations that are much better than the U.S., and there is a strong argument for lasting outperformance in both Europe and Asia. All of this is dollar bearish.