Thoughts through the cycle: W1 October ’20

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The US dollar – when is a haven not a haven?

  • It is often said that in the modern, digital world, everything happens faster than it used to. The feeling that the world is speeding up is not new. Industrialisation was for the nineteenth century what digitalisation is for the twenty-first century, and with it, there were those who harked back to a more sedate age. In France, the flâneur or ‘stroller’ movement saw gentlemen ambling along the boulevards of Paris with tortoises on leashes as that was the only pace sufficiently slow to be seen to be making a proper statement.
  • In some ways, the fiscal intervention by governments around the world following the Covid-19 outbreak can be viewed as a process of slowing things down or buying time while the tortoise-like process of creating and testing a suitable vaccine is ongoing. While there are those like President Trump and his 3rd November election deadline who have their own reasons for rushing the process, phase III vaccine testing is the difficult and slow part. AstraZeneca has been in the headlines recently with respect to some potential side-effects in its phase III trials. Back in 1976, a rushed flu vaccine with insufficient testing led to a number of cases of Guillain-Barré syndrome in the US eventually resulting in the vaccine programme being dropped (and notably in that case, insurers refused to underwrite the process as it had been rushed).
  • This problem of trying to keep things ticking over amidst the extraordinary disruption of the pandemic, lockdown, phased re-openings, and now re-lockdown is a question of liquidity and solvency. Can injections of liquidity prevent the eventuality of insolvency? With its status of reserve currency, the dollar is a key indicator of market liquidity. The fall in the dollar over the summer reflected not only rate cuts by the Fed but also the huge injection of liquidity into the financial markets via quantitative easing (QE). This is why stock markets soared. Those talking about V-shaped and the like were really just back-filling a narrative into a market liquidity story.
  • So when the dollar starts to rally, questions again have to be asked about market liquidity. The graph below shows the DXY dollar index (red) against the S&P 500 equity index (green). It is notable that the high-tick for equities at the beginning of September was the low-tick for the dollar. The dollar is clearly a currency, but is it something else as well?

Source: Bloomberg as at 28 September 2020.

  • The real (inflation-adjusted) cost of the dollar has not really changed all that much in the last month. The graph below shows gold (yellow) against 10yr US real rates (the nominal yield less 10yr inflation, blue, inverted). Gold is highly sensitive to changes in real rates,yet has notably underperformed real rates in September. This suggests that it is not the cost of the dollar which is the problem, but the actual number of them.

Source: Bloomberg as at 28 September 2020.

  • When the dollar was falling during the summer, market commentators began to voice fears about the durability of the dollar as the reserve currency in the light of QE and the large fiscal deficit in the US. An article in The Times expressed the sentiment very clearly:

‘“Real concerns around the longevity of the US dollar as a reserve currency have started to emerge,” Goldman’s analyst wrote. “Gold is the currency of last resort, particularly in an environment like the current one, where governments are debasing their fiat currencies and pushing real interest rates to all-time lows.”

The dollar’s reserve status is considered a special privilege, as it allows the United States to punch above its considerable weight as all dollar transactions are subject to US jurisdiction. Although the US accounts for 15 per cent of world GDP, half of all trade and two thirds of all currency reserves are in dollars. The March market collapse, prompted by a dash for dollars, underscored its dominance.’

(Fears over dollar’s reserve status as gold price soars, The Times, 29/07/2020).

  • The problem with this analysis is a conceptual one – the US may be debasing its currency hence gold is going up, but when gold tanks and the dollar rallies, is the US ‘un-debasing’ its currency, or is something else quite different going on? Bloomberg’s take on the recent dollar rally is as follows: “The dollar advanced by the most in three months as a slump in global stocks and concern about rising Covid-19 cases drove demand for haven assets.” (Dollar Surges Most Since June With Haven Status ‘In Full Effect’, Bloomberg, 21/09/2020). Debased in July, the dollar is now a haven, but one whose bonds are barely moving at all (2yr Treasury yields were 0.10% on the 3rd August and are 0.13% on 28th September, hardly a ‘flight to safety’ if judged in terms of demand causing yields to fall).
  • It seems that market commentators are struggling to describe what is happening. Part of this is thinking of the dollar as just one thing – a currency, and a special one due to its reserve status. As a reserve instrument, it is the only currency that people need to own rather than just want to own, hence the accusations of reserve status being an exorbitant privilege.
  • In the same way as the shift from the Ptolemaic view to the one proposed by Galileo meant a shift from a geocentric view of the universe to a heliocentric one, shifting one’s perspective from the US dollar and its reserve status as the centre to one were global debt is the primary focus starts to reveal what is really going on. Asset bubbles tend to burst when the credit behind them stops growing. Before the fiat money era, one could always choose to get out of the market and move into metal (gold, silver) if things were getting a bit hairy on the credit side. In a fiat money world, this is no longer possible, and as a result, there is nothing ultimately to stop debt building up (as there is no ‘out’). Unless defaulted upon, debt grows by itself through the compounding effect of interest through time. If debt is at the centre, then liquidity becomes an asset class that one can be long or short. As it has reserve status, the dollar is the measure of this liquidity, and thus a falling dollar means rising liquidity, and a spike means leverage is being taken off. The dollar rises because people need it, not because they want it. One can own dollars not because one is bullish on the dollar or the US recovery, but because one is taking a view against the build up of leverage in a deflationary world. If liquidity is indeed an asset class, then long dollar is the ultimate anti-leverage trade within it. This is why it spiked so sharply in March, even US Treasuries and gold (‘safe havens’ by convention) fell.
  • The problem of course is the passage of time. Interest accrues over time, and with it the stock of debt. Over time, the demand for cash rises. If one can’t pay, one has to default or go bankrupt. The serviced office company IWG (formerly Regus) is doing exactly that, defaulting on some of its subsidiary debt, potentially as a way of forcing landlords to concede to lower rents in the future (Regus goes to war with landlords, Sunday Times, 27/09/2020). Despite China’s recovery, property company China Evergrande (3333.HK) is also on the rocks for exactly the same reason. Prior to a press release on Friday 25th professing how the company is ‘stable and healthy’, the graph below of the price of Evergrande’s 12% of January 2024 US dollar bond shows the sort of distress normally linked to solvency issues.

Source: Bloomberg as at 28 September 2020. The name shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.

  • The shock to the commercial property market is also observable in the US. Some properties are being marketed lower by over a quarter of their holding value (Destruction of value in US real estate revealed, Financial Times, 27/09/2020). With tenants not paying their rent, the cash that normally services the mortgages is not being transferred, bringing into question the value of the properties themselves and the mortgages that back them. This all sounds a little bit credit-crunchy, only in tortoise-like slow motion. It was Mark Twain who allegedly said that bankruptcy happens very slowly then all at once. Too much debt, not enough cash. It is notable that the Evergrande bond above is a US dollar issue. Nothing haven-like about the dollar in this instance. This is where liquidity meets solvency.
  • Credit normally has a cycle, and within it, recessions are usually marked by deleveraging (balance-sheet repair) as households pay down debt and companies cut costs, pay off debt, and raise equity. The global response to the pandemic has actually seen the stock of debt rise not fall, and by this measure, one could argue that the recession has yet even to start. US investment grade and high-yield markets are set for record issuance in 2020. The US deficit could be on course for a level of around 20% of GDP. Not only has the flâneur got his tortoise on a leash, he’s actually walking him backwards.
  • What happens now? For markets to rally back to the highs and beyond, central banks need to print a lot more money. Given austerity is politically unpalatable, governments are likely to reduce the nominal value of their debt against GDP by generating inflation from fiscal spending. There may be some defaults on the way, and some tax hikes on the rich or on corporations, but it is likely that inflation will do the heavy lifting, if only because the fiscal spending which precipitates it is popular, and we are now firmly in the populist age. While political events such as the US election may provide a hiatus in the process, the direction of travel is clear. Even if there is a vaccine, it seems unlikely that governments will back-off from their spending plans, if only because cutting deficits means taxing and austerity, and in a fiat money era, these are ostensibly just policy options not necessities. In a debt-centric fiat money world, the dollar is not only the reserve currency but the global barometer of liquidity in all its forms. The fact it is rising suggests authorities world-wide need to do more.

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