Weaker USD a must for deleveraging global economy

In our Q1 outlook, we continued our argument in favour of the longer-term weakening of the US dollar, with the important caveat that at times, sharply higher US yields and a steepening yield curve in the US in anticipation of heavy incoming stimulus could support the US dollar and frustrate USD bears. From our Q1 outlook: “That brings us to the potential spoiler for an easy path lower for the US dollar despite the compelling fundamentals for the USD bearish case noted above: a steepening yield curve and a further rise in US long yields, which broke higher above key thresholds – like 1.00% for the US 10-year treasury benchmark – in the first week of 2021”. 

Indeed, a sharp acceleration higher in US yields later in Q1 helped to trigger a notable USD snap-back rally, particularly as the Fed seemed unimpressed with the move, with Fed Chair Powell merely indicating that the move “caught (his) attention”. The most intense portion of the rise in yields unfolded in the wake of a disorderly 7-year US Treasury auction, where there were even signs of market dysfunction and wide bid-ask spreads. The culprit was a complex mixture of factors, including plumbing issues in the financial system as US banks were bumping up against limits for how many treasuries they were willing or able to hold. At the same time, the US Treasury was winding down its account at the Federal Reserve (where it had built up a war chest of over $1.6 trillion last year to store up for pandemic-related spending), and this was creating disruptions at the shortest end of the yield curve and in US money markets. 

From here, the most rapid route to the resumption of a US dollar sell-off would be if longer US yields simply cool their heels for a while and don’t rise much above the cycle highs established in Q1, even as risk sentiment and the opening up continue to show solid economic activity and employment improvement in Q2. Yields have, after all, priced in some of the inflationary potential from the incoming stimulus and the basing effects from price crashes last year that will mean some very high inflation readings into the summer months. The US treasury also has a sufficiently large war chest to take us late into the year before it needs to vastly increase issuance, which would see yields rising from a supply/demand imbalance. 

Alternatively, the stimulus roll-out could so clearly be super-heating the US economy in coming months that US longer yields quickly pick up higher and begin breaking things again, together with a stronger US dollar. We see this as a self-limiting process, however, as at some level of rising longer yields and even a rising USD, the Fed (and more importantly the Treasury) will have to push back. This is the chief question in the longer term anyway for the US dollar – how does the US treasury keep itself funded? Going into Q4 and 2022, unless US savers decide to drastically increase their already high savings rates and/or new foreign buying interest comes on board for US government paper, the issuance gap will have to be closed somehow or it will crowd out investment elsewhere and send real interest rates unacceptably high.

Many, including this analyst, have thrown around the idea that the next natural step, given the incoming weight of treasury issuance, would be for the Fed to implement yield curve control. But on deeper consideration of the issue, we have concluded that the Fed is only willing to control yield out to perhaps three years; note Australia’s RBA is on the same page there. Controlling the entire yield curve is far too drastic in both the scale of intervention into the financial market, and because controlling that much of the sovereign yield curve is to underwrite the sitting government’s political platform – too drastic a step for the Fed. That doesn’t mean that yield curve control doesn’t happen eventually, but it would be on orders from the US Treasury and not up to the Fed’s own discretion. Next quarter is far too early for such a development.

Chart: USD vs. Global Equities and Commodities. It is clear to see from the chart below that a weak US dollar is critical for the performance of global asset prices and real growth, as it is effectively the world’s currency for funding. Note the important directional sympathy of commodities prices with the US dollar, and with that, note the generational low in commodities prices (in USD terms) during the worst pandemic months, as this index bottomed below even the 1998 trough (not shown). Finally, keep in mind that the commodities index is a nominal price series. World GDP in nominal USD terms since that 1998 trough in the Bloomberg commodities index has nearly tripled. Currencies associated with commodities should do well in relative terms for a generation from here.