Before King Dollar loses his throne, inflation will take off

Predictions of doom for the US dollar are not new and have so far come to nothing. Yet while it might not happen tomorrow, the risk warnings are there, says John Stepek – here’s how to get your portfolio ready.

Ever since the Bretton Woods Agreement in 1944, the US dollar has been the acknowledged top dog of global currencies – the reserve currency. And for almost as long, people have been predicting that it would be toppled from that position. As yet, of course, it hasn’t happened. But with Donald Trump running the public finances as imprudently as he managed his own, and his opponents talking about printing money to fund pet projects, could it be different this time?

The case against the dollar

There are at least two good reasons to fear for the durability of the US currency right now. Firstly, absolutely no one with any power over the dollar has any obvious regard for preserving its value. President Donald Trump is a spender, not a saver. “Fiscal hawks” (politicians who aspire to keep spending roughly in line with, or below, the tax take) are often associated with the Republican party. But even in their own party they are a minority. A package of tax cuts has seen America’s deficit (its annual overspend) balloon under Trump. As a result, the national debt – already standing at around $22trn, or more than 100% of GDP – is set to race higher (and as hedge-fund billionaire Ray Dalio of Bridgewater Associates notes, this is before you start talking about unfunded spending on “entitlements” such as healthcare and pensions). The highest-ever level for the US was around 119% seen in 1946, just after World War II.

Meanwhile, Trump’s main political opposition, the Democratic party, has no intention of being fiscally responsible either. Indeed, the biggest policy idea firing up the American left right now is a “Green New Deal”, which would be funded in accordance with the tenets of modern monetary theory (MMT). In other words, it wants to spend a huge amount of money on revamping America’s energy infrastructure, and it would raise the money not through taxes, or through borrowing, but simply by getting the government to print it (this is the basic idea behind MMT, nicknamed “magic money tree” for obvious reasons).

Finally, despite Trump’s huge tax-cutting splurge (which should, in theory at least, stimulate the economy and therefore justify higher interest rates), the Federal Reserve – the US central bank, and thus de-facto guardian of the currency’s purchasing power – has apparently capitulated to stockmarkets and abandoned the idea of raising interest rates any further this year. Indeed, the Fed’s next move is to work out when it will end the current quantitative-tightening (QT – the process of reversing quantitative easing) programme.

Fed chairman Jerome Powell has repeatedly warned that the US needs to deal with its debt. But unless he forces the issue by jacking up interest rates, politicians are not going to pay any attention (why bother cutting spending or raising taxes if you can either print the money or get the Fed to do it?). And in any case, the Fed itself now looks as though it is more worried about recession and more keen to loosen monetary policy than to tighten it, which – all else being equal – is not good news for the dollar either.

“Democrats want to print money to spend on green energy”

As for the other good reason to question the dollar’s continued reign, one aspect of being the reserve currency is that, to use a computer metaphor, the dollar effectively acts as the operating system for global finance and trade. It’s Microsoft Windows for money, if you like. What has become increasingly clear in recent years is that the US is both able and willing to lock countries and individuals out of this operating system should it see the need. For example, as Luke Gromen of the Forest for the Trees newsletter points out to Real Vision’s Grant Williams, 2012 was a “real watershed moment” on this front. The US, using economic sanctions, effectively locked Iran out of the global financial system, hammering the Iranian rial and helping to drive inflation higher. Russia has also been the target of similar sanctions.

The problem, argues Gromen, is that “it was a penny wise, pound foolish decision by the US. Because it’s a weapon you can only use once… They did it to Iran and they caught Russia’s attention. They caught China’s attention. Anyone else in the world who figured they might be on the wrong side of the US any time in the next five, ten years, had to start thinking about the fact that the US could, within two weeks, completely choke out your economy, starve your people”. No one wants to be stuck with an unreliable operating system – and it’s certainly true that some countries appear to have stepped up their hunt for an alternative to the dollar. For example, Russia sold off almost all of its US government-debt holdings last year, either in retaliation against US sanctions on prominent businessmen, politicians and companies, or more likely due to concerns that its dollar assets would become untradeable.

The case for the dollar

Against all this, of course, there are a huge number of factors that remain in the dollar’s favour. As financial historian and analyst Russell Napier points out, the dollar is backed by what is still the world’s most powerful economy, safeguarded by strong institutions that underpin property rights and democracy, not to mention the world’s most powerful military. As credit-rating agency Moody’s puts it, “the transparency of the US financial markets as well as the stability and predictability of US monetary policy reinforces the safe-haven legacy that the US dollar holds”. Nowhere else in the world offers that kind of security (which is, of course, one reason why many in the US currently appear to believe that it should be possible for the US government to print as much money as it wants without triggering any sort of upset in global markets).

And this, in short, is the problem: yes, the dollar has its issues, particularly right now. Howard Marks, the billionaire distressed-debt investor and contrarian, highlighted the national debt in a conversation with Bloomberg, warning that “there is probably such a thing as too much”. But at the same time, if you want to challenge the dollar as the operating system for global finance, then you have to have something to replace it with. And options are thin on the ground.

The second most-used currency in the world right now is the euro, and indeed one driving force behind the euro’s creation was to build a trade bloc that could rival the US in terms of economic, if not military, clout. However, the problems with the euro are extremely clear to all but the most blinkered europhile. Question marks still hang over whether it can survive in the long run, and if so, what will be the nature of the institutions backing it?

“The idea of a digital currency displacing the dollar is intriguing, but unlikely”

China’s currency, the yuan, is the other obvious candidate, given that China is the rising superpower (just as the UK saw sterling lose its crown to the US). But China is also a long way from having the institutions and financial and political freedoms required to make the yuan a viable reserve currency.

The idea that cryptocurrency might play some role in the future financial system is more intriguing. Since the big bitcoin crash of 2018 much of the heat has come out of the digital-currency market. The current fad is for “stablecoins” – cryptocurrencies whose value is tied to another widely accepted asset, such as the US dollar, or perhaps even gold. The idea that stablecoins might eventually become the fast, reliable medium of exchange that bitcoin has so far failed to be is interesting – but the prospects of such an early stage technology replacing the world’s reserve currency any time in the near future seems even less likely than the euro or the yuan taking the top spot.

What could start the dollar’s decline?

In the immediate term, several analysts note that the current trade dispute between the US and China could pave the way for some sort of deal on currencies that kick-starts the slow process of the yuan becoming a reserve currency itself. Some argue that a Plaza Accord-style deal (named after a 1985 deal to allow the US dollar to weaken against the Japanese yen) might be forthcoming, whereby the Chinese agree to keep the yuan relatively stable against the US dollar, in return for no further sanctions. Gromen argues that “if we get a comprehensive trade deal… with a strong and fairly obvious foreign exchange component that weakens the dollar institutionally against the yuan, and probably other currencies, then I think the outlook is quite weak for the dollar”. Louis-Vincent Gave of Gavekal agrees that a “Plaza-Lite Accord” of this sort “would be a game-changer for markets” (more on what it would mean for investments in the box on page 26).

In the longer run, it’s not the revaluation of the yuan that concerns the bears. As far as Dalio and others who worry about the debt are concerned, the big risk is that the US will be unable to sell US Treasuries at an interest rate it can afford to pay. “We have the privileged position of being able to borrow in our own currency because we have the world’s leading reserve currency. We are risking that by… borrowing too much.” Domestic buyers, fears Dalio, won’t have the capacity to soak up the future supply, and foreign buyers won’t want to. Thus the Fed will have to step in and use printed money to buy up government debt – explicitly “monetising the deficit”. That could panic investors. Dalio argues that you could easily “have a 30% depreciation in the dollar through that period”.

The question is: what could trigger that sort of reaction? The idea that “deficits don’t matter” has gradually taken hold in the wake of the 2008 financial crisis. When the crisis first hit, huge sovereign-debt piles (partly the result of countries bailing out their banking systems) were still viewed as something to be feared. It seemed only a matter of time before the “bond vigilantes” struck in many countries. Yet instead, bond prices kept rising and yields kept falling.

“The Fed is looking for an excuse to allow inflation to ‘run hot’”

This wasn’t all down to central banks buying their own governments’ debt. Instead, the main driver of sliding yields has been the deflationary backdrop. When inflation is low and falling, then bonds – which offer a fixed income – become increasingly appealing (you’ll be willing to pay more for a fixed payment when prices are rising slowly, than when prices are rising fast). As a result, demand for bonds has been underpinned both by central banks and by high demand from buyers looking for assets that can protect them from the deflation bogeyman. As that environment has continued for longer than anyone had expected, many (notably politicians) have started to believe that inflation will never take off, regardless of how much money is printed.

That strikes us as foolhardy. It’s worth noting that history suggests (according to a pretty exhaustive study of past bank crises by economic historians Carmen Reinhart and Ken Rogoff) that recoveries from bank crises take much longer than recoveries from “normal” recessions. So there is no real justification for believing that “it’s different this time”. And indeed, as Charles Gave of Gavekal points out, there are signs “that the US may be entering a period of structural inflation”. As well as the tight labour market and evidence of rising wages, Gave notes that when the return on gold is outperforming the return on ten-year US Treasuries – as it is now – this tends to indicate that “the US economy is transitioning to a different macro-environment” – in this case from a deflationary environment to an inflationary one.

What if inflation makes a comeback?

The obvious question is: won’t the Fed step in to prevent inflation from taking off? That’s certainly what was worrying the market last year. Yet the Fed is now apparently looking at changes in the way it targets inflation. To cut a long story short, the Fed is considering targeting a long-term average inflation rate rather than the current specific 2% target. However, given that inflation has spent more time under the 2% target than above it in recent years, this suggests that the Fed may use the new framework (assuming it changes) as an excuse to allow inflation to “run hot” for some time.

What does that imply? For one, it suggests that bonds will no longer be structurally attractive.

If prices are rising at an ever increasing rate, the last thing you want to own is a fixed-income asset. This suggests that US government bond prices would need to fall, potentially quite hard, to tempt investors. That could spark the sort of buyers’ strike that might force the Fed to “monetise the deficit” – and it would have many other implications too, as we examine below.


How to prepare for a declining dollar

The dollar could take a very long time to come to lose its place as the world’s most important currency, and – as we note above – before it does, we’ll probably have to see inflation take off. So if you are concerned about the dollar’s demise – or at least, its being dislodged from its perch, then prepare your portfolio for inflation first.

The most obvious asset to invest in if you have concerns about the state of the financial system is gold. Central banks have been loading up on the yellow metal at a rate that we haven’t seen since President Richard Nixon finally took the US dollar off the gold standard once and for all in 1971 (up until then the US dollar had been convertible to gold at a fixed rate of $35 an ounce, but fears about heavy spending on the war in Vietnam and its impact on America’s balance sheet meant that foreign governments were increasingly cashing in their dollars for gold until Nixon put a stop to it). According to the World Gold Council, central banks in all added more than 650 tonnes to their official gold reserves in 2018. If you don’t own any gold, you should probably follow them.

You can buy physical gold in many ways – for example, Sharps Pixley sells bullion both online and from its showroom in London, while BullionVault offers a straightforward way to buy gold, silver or other precious metals online. If you’re not overly concerned about being able to hold the gold in your hand, you can simply buy an exchange-traded fund (ETF) – one popular London-listed option is the ETF Securities Physical Gold (LSE: PHAU).

Another side-effect of a more inflationary world is that “long-duration” assets – those that have benefited the most from low and falling interest rates – will no longer be in vogue. This covers everything from long-dated bonds to “jam tomorrow” growth stocks. So any shift to a more inflationary environment could be the long awaited trigger for value stocks to finally make a comeback. You could look at a contrarian-orientated, value investment trust such as Temple Bar (LSE: TMPL) as a way to position yourself for any such turnaround.

Meanwhile, if the US and China do agree to China revaluing the yuan “over a sustained period”, says Louis-Vincent Gave, then this “would be bullish for Asian currencies and bonds, as suddenly they would lack natural sellers. With a rise in Asian currencies and an across-the-board drop in regional interest rates, Asian consumers would secure a huge purchasing-power fillip – Asian consumer stocks would surely rocket. Across the Pacific Ocean, such an outcome would be bad news for US consumers, whose purchasing power would diminish.

There are plenty of decent investment trusts to consider if you want to invest in Asia, several of which we covered in our recent story on the region. For smaller companies, take a look at the Scottish Oriental Smaller Companies Trust (LSE: SST) – currently trading at a discount to net asset value (the value of the underlying portfolio of shares) of around 12% – or the Aberdeen Standard Asia Focus (LSE: AAS), for example – on a discount of around 11% – or for something more focused on larger caps, the Schroder Asia Pacific Fund (LSE: SDP), which is currently on a discount of around 8.5%.