James Bevan: Dollar de-leveraging

Last week’s FOMC (Federal Reserve’s Federal Open Market Committee) statement probably represented something of a surprise to markets, but the clear message within much of the latest US data has been one of growing weakness, not just in retail sales but also in durable goods and capital expenditure.

The weaker than expected data may reflect the challenge that the market consensus typically starts the year rather too optimistically when it comes to global and, indeed, US growth prospects, and by the time the second quarter arrives growth estimates have been pared back. But the consensus was slow to notice that (non-oil) price deflation had begun in the US, and was sapping corporate profits and economic growth in general, even whilst the Atlanta Fed’s own GDP-Now indicator had been signalling significant weakness in the economy.

As a result of the weaker than expected growth, the perceived probability of the FOMC actually raising interest rates at all this year has retreated markedly. But there may now be more chance of the FOMC actually raising interest rates because of the problems associated with being at the zero bound and the negative impact on growth, rather than the Fed raising rates to contain the economy’s expansion.

Whilst markets see reduced chances of a rate hike, the dollar has stayed strong and this may be down to its reserve currency status, given that global trade and indeed many capital account transactions are settled in the reserve currency, and the economy that provides the reserve currency needs to ensure that it is a net exporter of its currency so as to accommodate global growth. Hence the growing need for reserves and international settlement funds.

As an aside for students of finance history, during the Bretton Woods era this requirement was identified by Belgian economist Robert Triffin as implying that the US needed to run persistent current account deficits in order to supply an ever-increasing supply of dollars to the world. This situation did, however, imply that the US would also find itself amassing substantial liabilities to the foreigners that owned these claims on the Federal Reserve (i.e. dollars), which Triffin identified as representing a potential problem for the US itself. Indeed, the so-called Triffin Dilemma for the US came to be defined by “the conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies”.

With today’s open economies,  the purchase of a security by a US resident in a foreign country is just as capable of providing dollars to the rest of the world as is the purchase of another country’s exports by a US-based entity. And whilst between the mid-1950s and the late 1990s, the supply of dollars from the US to the rest of the world essentially expanded by the same dollar amount that the US economy was itself expanding, by the mid-2000s, the US was exporting dollars at almost six times its usual rate relative to the growth in its GDP. Mr Greenspan as Fed chairman signalled his intentions far in advance, moving cautiously and predictably, protecting the global system, with a large part of the credit boom based on the explosion in the export of dollars from the US.

Apart from the internationalization of US “savings”, this period also involved the rise of the “carry trade”, with dollars flowing either to emerging markets (EMs) or the relatively high-yielding southern hemisphere currencies, with these two groups receiving $8-$9tn of cumulative inflows into their debt markets alone. Key recipients of dollar flows have included Brazil, Australia, China, South Africa and Turkey with recipient countries using the inflows to fund significant expansions of domestic credit.

The export of dollars and flows to EMs have dwarfed global nominal GDP growth and indeed in dollar terms, Euroland’s nominal GDP is now over 10% smaller than it was a year ago. Japan’s is 11% smaller in dollar terms, Brazil’s is some 7-8% lower, China’s is likely unchanged and the UK’s is a little lower. As a result there is no longer the same level of dollar-denominated GDP to support all of the dollar-denominated debt and we face the risk of an international dollar de-leveraging cycle.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla