Making Sense of U.S. Dollar Cycles

Our Daily Pfennig® Currency of the Month series has traveled the world of actively traded currencies since relaunching coverage in early 2015, but the one major currency that has been conspicuously absent from our microscope has been the U.S. dollar. The currency is often forgotten as a tradable currency by U.S.-based investors, presumably due to the fact that most U.S. investors are already heavily exposed to U.S. dollar investments through equity investments, bond holdings, home values, and deposit accounts. But the outlook for the U.S. dollar will clearly have an impact on most paired currency trades.

My opinion on the U.S. economy should present readers with very few surprises, which has been addressed in daily musings in terms of the systemic and structural problems plaguing the economy, from U.S. debt levels approaching $20 trillion dollars (nearly 75% of GDP), deficit spending in excess of half a trillion dollars (-2.4% of GDP) per year,1 and a Federal Reserve balance sheet that has ballooned by $3.5 trillion dollars since 2008 (Figure #1). Since abandoning the gold standard in the early 1970s, the U.S. Central Bank has managed the dollar just like every other fiat currency in the world: Printing money at will to provide stimulus for the economy.

Fig. #1
Total Assets of All Federal Reserve Banks

Source: Board of Governors of the Federal Reserve System (US), All Federal Reserve Banks: Total Assets [WALCL], retrieved from FRED, Federal Reserve Bank of St. Louis;, July 24, 2016.

Yet placing aside these familiar arguments against the U.S. economy, it is still an irrefutable truth that the U.S. dollar is considered, throughout most global markets, as the strongest and safest currency around. (Cue ‘spit-take’ from the readers’ morning coffee!) Now, loyal readers should not go thinking that I have abandoned my long-standing views that the U.S. economy remains on a downward spiral based on burgeoning debt levels, slowing economic growth, and excessive monetary stimulus efforts. Indeed, my views on the U.S. economy remain steadfast in foretelling an ongoing weakening trend in the dollar.

Yet the obvious question remains as to how these two seemingly conflicted views can be reasonably resolved. More precisely, if the U.S. economy is considered by most to be the world’s strongest, most stable economy, why would investors even consider purchasing a currency other than the U.S. dollar? The answer, of course, lies in the cyclical nature of the U.S. dollar.

The Complicated Currency Market Structure
In order to evaluate longer-term trends in the U.S. dollar and anticipate changes, it is always best to take one large step back from the day-to-day data and cross-currency complications, and instead take in the bigger-picture macro factors that influence trading in the U.S. dollar. But in order to track these long-term cycles, it is important to determine just who is trading in the U.S. dollar, and for what purpose. As always, we bear in mind that past results are no guarantee of future performance.

The U.S. dollar is undeniably the world’s most dominant currency vehicle, representing about 87% of the $5.3 trillion daily volume traded on one side of a transaction.2 Of the counterparties participating in global currency trading, financial institutions including small banks, institutional investors, hedge funds, and proprietary trading firms make up roughly 50% of the volume, with foreign exchange inter-market dealers and non-financial customers making up the remainder (Figure #2).

Fig. #2
Foreign Exchange Market Turnover by Counterparty

Source: BIS Triennial Central Bank Survey, April 2013.

Non-financial entities are corporations that use the foreign exchange markets to passively hedge currency translation risks for international transactions, while dealers are market makers within the currency market, creating liquidity for investors and setting currency pricing spreads. Investment decisions from these two trading groups are not necessarily correlated to financial institutions making currency decisions based on economic fundamentals, so currency trends are inherently muddied by these divergent trading intentions. Moreover, currency markets are complicated by intervening policies from government central banks, whose motives for trading currencies may have further divergent goals, such as setting interest rate levels, controlling inflation, or managing import/export goals.

The very point, therefore, is that evaluating trends within a certain currency, even the U.S. dollar, is particularly challenging given the potential host of conflicting investor motivations. Often times, it is not the underlying fundamentals that drive currencies over short-term periods.

Evaluating Cycles in the U.S. Dollar
To provide a reasonable environment for evaluating the U.S. dollar cycle, we believe it is best to simplify the analysis rather than getting mired in the complicated task of normalizing the aforementioned factors. Taking a long-term cyclical view of the U.S. dollar since leaving the gold standard in 1971, we can identify periods of relative strength or weakness in the U.S. dollar to help identify broad macro reasons for these trends. The Swiss franc is one of only a few currencies that have not materially changed since the U.S. abandoned the gold standard, and therefore, is a useful proxy for evaluating periods of strength and weakness in the U.S. dollar.

The dollar’s initial weakening cycle began in 1971, immediately after the U.S. Central Bank dropped the gold standard, during a period of spending deficits and excess money supply used to fund the later years of the Vietnam War. The U.S. dollar cycle strengthened during the ensuing period, from 1978 to 1985, which was characterized by government policies supporting reduced social spending, relaxed regulations, lower taxes, and higher interest rates. The Plaza Accord of 1985 set the stage for a 10-year period of cyclical weakness in the U.S. dollar through concerted intervention efforts by the U.S., U.K., Germany, Japan, and France to reduce the value of the U.S. dollar and level trade imbalances, and the U.S. technology market boom and budgetary surpluses of the late 1990s provided the inflection point for the U.S. dollar to strengthen into the early 2000s.3

The period of dollar weakness between 2002 and 2011 can be attributed to a wide range of variables, including the 2000 tech bubble crash, terrorist events of September 11, 2001, costly Iraq and Afghanistan wars, Enron and WorldCom accounting scandals, subprime mortgage defaults, global recession, deficit spending, excessive increase in the supply of money, and an unprecedented expansion in the Federal Reserve’s balance sheet. Based on such an exceptionally unfortunate decade in the history of the U.S. economy, it should therefore come as little surprise that the U.S. dollar would find some footing over the past five years as these issues faded into the background, but are likely just waiting to be replaced by the next global event.

Outlook for the U.S. Dollar
The unanswered question, of course, is how long a dollar-strengthening trend can last within this environment? If the current strength in the U.S. dollar was fundamental in nature, that is, characterized by budget surpluses, declining debt, economic growth, or higher interest rates, we would be hard pressed to call an end to the relative strength. The more likely case to be made, however, is that the U.S. dollar has been the recipient of favor with investors from the global “flight to safety” as European debt problems surfaced from Portugal, Italy, Ireland, Greece, and Spain (remember the PIIGS?), and more recent negative interest rate policies (NIRP) in Europe and Japan. It is anyone’s guess as to whether the next global issue will confirm or turn the tables on the recent U.S. dollar trend, but history would seem to indicate the latter.

The strength in the U.S. dollar during the current cycle appears to be getting long-in-the-tooth, considering the cycle is roughly 18-months short of the duration for the last two cycles. While this observation may not have a scientific basis, it would be difficult to argue that the conclusion is not valid absent any fundamental change in the underlying U.S. economy. It is also useful to note that periods of U.S. dollar weakening tend to have greater downside risks, as compared to the periods of up-dollar trends. Additionally, the most recent period of modest outperformance would seem to indicate a relative lack of conviction with respect to rotations into the U.S. dollar.

Based on recent economic reports from what I like to call the “Real Economic Data,” the U.S. economy appears to be heading towards another slowdown/recession, with many of the government releases indicating reports in negative territory (Figure #3). Moreover, current 10-year U.S. Treasury yields hovering around 1.5%4 since the beginning of July 2016 appear to confirm a bleak U.S. economic growth outlook.

Fig. #3
Real Economic Data Variables
(From most recent data available – annualized)

Source: U.S. Bureau of Economic Analysis, U.S. Census Bureau, St. Louis Federal Reserve FRED Database. Chart: EverBank Research Team.

A seasoned technical market analyst for a major investment bank was once asked for his thoughts on the cyclical nature of the markets. His response was, “Trends in markets tend to remain in place. That is, until they change.” This simple, yet profound statement seems to perfectly capture the essence of our views on the outlook for the U.S. dollar. And based on recent economic data points, the fundamental data appears to be stacking up against the U.S. economy. At some point, the scales will likely shift against the U.S. dollar, and revert back to a weakening dollar trend.

Until the next Daily Pfennig® edition…

Chuck Butler
Managing Director
EverBank Global Markets Group