After a lacklustre start to 2018, the dollar index DXY, which measures the US dollar’s performance against a basket of six developed-market currencies, rose around 7 per cent from its February low of 88 to above 94 on 18 September. On the same day, one Australian dollar (AUD) bought around 72 US cents, having traded at nearly 78 US cents at the start of the year.
The direction of the US dollar is also pertinent to the outlook for emerging markets (EM) assets. Firstly, most developed-market investors in EM equities or local currency bonds do not hedge their currency exposure. As EM currencies generally move in unison against the dollar, investors in EM assets are vulnerable to pronounced dollar strength because of their direct foreign exchange exposure. Secondly, EM equity and bond prices generally go down when the US dollar climbs, creating a double whammy for foreign investors who incur currency losses and suffer declines in security prices. Australian investors have been slightly better off than those in the United States because the Australian dollar has also weakened against the US currency over the last six months, somewhat dampening the EM-related foreign exchange losses for Australian superannuation funds.
A strong US dollar reflects tightening global liquidity conditions, which are harmful to commodity-related and emerging markets assets. The strain in US dollar funding markets comes from the coincidence of two developments:
- the US Federal Reserve’s well-telegraphed reduction of its balance sheet, and
- the less well-anticipated and substantial increase in US Treasury bond issuance to finance President Trump’s tax cuts and fiscal stimulus.
In October 2017, as part of exiting the unconventional policy mechanisms enacted after the global financial crisis, the Fed began its “balance sheet normalization”. The Fed has since started shrinking its balance sheet by limiting reinvestment of the coupons it receives from its Treasuries holdings. The pace of this quantitative tightening will gradually quicken to $50bn a month and reach a total $1tn by December 2019. When the US central bank decided to embark on this program, it did not know the Trump administration would manage to push through very sizeable tax cuts and higher government spending. According to our calculations, the larger budget deficit resulting from this fiscal stimulus will lead to net Treasury bond issuance of around $1.2tn per year over the next two years.
Less supply of dollar liquidity by the Fed and more demand for dollar funding by the US Treasury have reduced flows from the US to the rest of the world, particularly emerging markets. Against this backdrop of tightening US dollar liquidity and the threat of capital outflows from emerging markets, investors will be forgiven for thinking a stronger US dollar is almost inevitable. We disagree.
Assessing the prospects for the dollar from the perspective of Russell Investments’ cycle-valuation-sentiment investment decision-making framework, we conclude that Australian investors should not chase the current rally in the US dollar and also look to other safe-haven currencies for diversification. Three factors to be taken into account are:
- Business cycle: Cycle forces remain slightly positive for the US dollar, but are finely balanced between supportive and negative factors. While we see the interest rate differential and recent positive economic data as tailwinds for the dollar, the market has already priced in future interest rate increases in the United States. Conversely, other advanced economies are now catching up with the US after a period of economic divergence in the first half of 2018. In the longer term, the US federal budget and the current account are weaknesses likely to weigh on the dollar.
- Valuation: The US dollar is expensive. The trade-weighted exchange rate suggests that the greenback is around 10 per cent overvalued against a basket of developed market currencies. This is corroborated by the deviation of the dollar exchange rate from its purchasing power parity (PPP) level against the euro, the Japanese yen and the British pound. Against all three of these major currencies, the US dollar is overvalued on a PPP basis. However, the US currency is not rich vis-à-vis the Australian dollar as the fair value of the AUD/USD exchange rate is around 0.68.
- Sentiment: This is neutral. On the one hand, momentum of the US dollar has improved and swung from negative to positive over the last four months. One-sided positioning was an important driver of recent US dollar strength. Speculative investors had a very large net dollar short at the beginning of 2018, but have since sharply reversed that bet, thereby pushing aggregate speculative USD net long positions towards 13 per cent of open interest. We are very wary of chasing dollar strength as bullish sentiment looks stretched now.
Rather than only relying on the greenback to act as a diversifier to global stock market risk, we think that exposure to a well-balanced mix of safe-haven currencies is a better approach.
What does this mean for Australian super funds?
Given the advanced age of the current bull market in equities, it’s wise for Australian super funds to think about the diversification benefits of currencies and leave some of their foreign exchange exposure unhedged. So-called “safe-haven” currencies are especially of interest as they tend to rise against the Australian dollar when risk assets fall. We have looked at the historical performance of developed-market currencies during episodes of world equity bear markets, defined as declines of at least 20 per cent in the MSCI World index, and US recessions as defined by the National Bureau of Economic Research from 1973 until the present.
Of the ten most liquid developed-market currencies (which includes the Australian dollar), the strongest average performers during an equity pullback of at least 20 per cent are the Swiss franc, the Japanese yen, and the euro. During a US recession, the strongest performers are the Japanese yen, Swiss franc, and the US dollar.
Rather than only relying on the greenback to act as a diversifier to global stock market risk, we think that exposure to a well-balanced mix of safe-haven currencies is a better approach. If we had to pick one currency, the Japanese yen is our favourite based its on very attractive valuation.