What’s unsettling the US dollar?

As the US dollar weakens, it pays to understand why it was so strong in the first place – and what’s changed, says Sean Corrigan of Cantillon Consulting.

The dollar has had the worst year since 1985, the headlines have screamed for this past week or so. There is no doubt that the US currency has been struggling (the precise truth of the statement rather depends on the specific dollar index one uses). Yet it comes after five and a half years of notable strength, during which the dollar rose by around 45%.  So rather than look at why the dollar is now falling, it may be more informative to look at why it was strong in the first place – and at what has changed.

One significant factor driving the dollar higher has been the global appetite for US corporate debt, of which foreign buyers have bought more than $350bn over the last two and a half years. This has made a meaningful contribution to the whopping $860bn issued by US non-financial corporations over that time, which in turn has been used to fund roughly two-thirds of their $1.3trn-plus of stock buybacks. Although a good part of this overseas demand will have been currency-hedged, not all of it has been, thus helping to push up the dollar alongside the S&P 500 (now at an historically elevated level in relation to its global peers). Much of this appetite for US bonds has arisen from the urgent need to escape central-bank-engineered negative yields at home. For example, as a result of Mario Draghi at the European Central Bank (ECB) continuing to do “whatever it takes” long after the obvious need to do so has passed, the yield differential (or “spread”) between US Treasuries and their German counterparts had recently reached its highest level since the fall of the Berlin Wall.

Now, however, some of those factors are starting to unwind. Doubts are creeping in about the ongoing momentum of the US economy, while few concrete measures are expected to be enacted to alter its course. As a result, US bond yields have dropped back from near-two-year highs of 2.6% to today’s midrange 2.2%. Simultaneously, several rounds of more positive monthly data from across the Channel have prompted talk that, perhaps as soon as this autumn, the ECB council might finally have to give some ground to its northern European critics, who are keen to rein in quantitative easing. The same hint of a long-awaited renaissance saw European stocks finally do better than US ones in the first half of this year, which in turn has contributed to a positive reassessment of the euro’s prospects, sending the single currency soaring against the dollar.


“IT’S TIME TO STOP WORRYING ABOUT THE US DOLLAR AND PAY MORE ATTENTION TO COPPER”

What does this change of tone suggest for the broader market and your own portfolio? There are widespread signs that both global trade and industrial output are picking up. Global air freight tonne-kilometres were up more than 10% in the first six months of the year – their best showing since the rebound from the depths of the financial crisis. Passenger miles, too, are up nearly 8%: the steepest climb in 12 years. More generally, world trade volumes are up more than 5% year-on-year, the strongest figures in six years, while dollar values are also at a six-year high – helped by the rebounding price of many of the bulk commodities involved in this trade. As for production – typically a far less volatile indicator – that is at a three-year high.

All of these factors are positive for industrial commodities and, in particular, for base metals. Research we have carried out at Cantillon Consulting shows that when the dollar trades poorly relative to its trend of the preceding three years (which includes a slower rate of climb, as well as an outright decline), commodities tend to do well. Similarly, when trade and industrial activity each pick up relative to their own recent respective trends, commodities again tend to rally. A further series of correlations can be found with both absolute and relative performance of emerging-market (especially Asian) stocks, as well as with those in the traditional resource countries, Canada and Australia.

To add to all this, there’s the fact that commodities returns are languishing at multi-year lows compared with both equities and bonds, and are generally an unloved asset class, whose long years of disappointing returns have provoked an exodus by investors, closures by some big-name hedge funds, and the withdrawal from the market of several large banking houses. Look at it like that, and it might just be time to stop worrying about whether or not the US dollar can resist the pull of gravity, and to check the pulse of Dr Copper – the metal with a PhD in economics – in particular. It has risen strongly in recent weeks, but having fallen 60% from the 2011 peak to the trough, it could still have further to go.