Why ‘The Tide Is Going Out On US Dollar Exceptionalism’

In “Exceptionalism Lost”, I placed recent US dollar weakness in the context of America’s failure to stop the spread of COVID-19. In previous work, I’ve suggested that fractious domestic politics and social tensions threaten to forever alter the way the rest of the world perceives the US.

The transmission mechanism from the ongoing epidemic to the currency is relatively straightforward. As more states are forced to pause or rollback the re-opening push, the prospect of a durable economic rebound becomes commensurately more remote. The weaker the economy and the further out the recovery, the longer monetary policy will have to remain accommodative and the more fiscal stimulus will be necessary to help cushion the blow from what could become structurally higher unemployment and persistently depressed consumer spending.

Between the weaker economy, lower for longer rates, ongoing asset purchases from the Fed, and consistently large deficits, the fundamental case for the dollar is eroded. At the same time, the perception that the US suffers from intractable political dysfunction and growing politicization of monetary policy, undermines investor psychology, as does pervasive societal unrest tied to myriad inequities and prejudices seen as increasingly incompatible with the prevailing attitudes and ideals that characterize other modern, developed nations.

Read more: Exceptionalism Lost

Add to the above growing concerns about the extent to which the dollar and the US financial system have been weaponized to punish other nations for perceived transgressions both large and small, and the fact that stability in emerging markets hinges to a great degree on the Fed not erring by over-tightening during a hiking cycle, and there is a very good case to be made that gradual de-dollarization is desirable.

Regular readers know I do not believe that rapid de-dollarization is feasible, let alone likely. As discussed here earlier this week, there are logistical hurdles that are simply too high to clear. For example, the petrodollar system is deeply entrenched, and China has to recycle its savings. Arguably, there’s no market deep enough and liquid enough to accommodate those flows outside of US Treasurys.

And yet, the de-dollarization theme and the (related) idea that American exceptionalism is fading, are suddenly en vogue, thanks not just to the decline in the dollar itself, but also to gold’s furious rally.

In a note out Wednesday called “The tide is going out on USD ‘exceptionalism'”, Deutsche Bank’s Alan Ruskin touches on a number of the points mentioned above.

“A big cycle USD top is very likely in place”, Ruskin writes, kicking things off by noting that after three years of ranking first among G10 countries in both short- and long-term rates, “US yields are now far from exceptional, and are the most visible FX metric that ‘the tide on USD exceptionalism’ is going out”.

Of course, when the Fed rushed to cut rates to zero, the world was in a panic. In March, the dollar surged alongside US real rates, but that episode reflected a state of absolute chaos wherein everything that wasn’t tied down (including gold) was sold indiscriminately to raise USD cash.

The Fed stepped in with swap lines and a foreign repo facility (both of which were extended to March of 2021 on Wednesday) and things calmed down.

With that episode in the rearview, “we still do not have a clear understanding of whether the collapse in USD rates are fully priced, and what constitutes a source of stable US Current Account financing”, Ruskin says.

But it’s not just the crumbling of the rate differentials pillar. Remember, QE functions to create de facto negative rates while simultaneously absorbing issuance tied to fiscal stimulus.

“Quantitative easing makes up for the constraints of the zero rate bound [and] facilitates smooth fiscal financing”, Ruskin notes, adding that,

Initially the FX market rewarded proactive Fed QE, with a stronger currency, but like we saw back in 2009 – 2012, QE when repeated, starts to become a symbol of ‘weakness’. At a minimum, it shows that past easing has been insufficient, or, that from a fiscal perspective, more money financing of debt is necessary. In short, we are already at the stage where more easing from the Fed will be regarded as a USD negative.

Needless to say, nothing in Jerome Powell’s remarks Wednesday suggested that the Fed is anywhere near contemplating tighter policy, and will surely resort to more easing at the first sign(s) of real trouble, which could be coming sooner rather than later given the leveling off of the recovery trend.

Ruskin goes on to document the same points made here on Monday regarding the country’s inability to get control of COVID-19.

“Of late, the biggest knock to ‘US exceptionalism’ has been precipitated by the virus data”, he writes, noting that “US ‘virus divergence’ from many other developed countries has triggered expectations of economic divergence, and more policy easing that is a clear USD negative”.

Meanwhile, the “twin deficit” problem is a persistent knock against the greenback and it’s especially poignant now.

One thing I’ve been keen to emphasize is that almost every country that “counts” (so to speak) is borrowing and spending, so it’s not as if the US is alone. I ran through the numbers on that via a few handy visuals in “The Dangers Of Deficit Dogmatism And The Courting Of Disaster“.

But Ruskin notes that even as “most countries are going to see the worst general government deficits in peace-time… the US suffers from the worst starting point among OECD countries, and the post-COVID fiscal actions have supported short-term consumption more than sustained employment”.

And then there’s the geopolitical angle, which I tend to emphasize by force of habit.

Sino-US tensions ratcheted materially higher last week with the forced closure of the Chinese consulate in Houston and an in-kind shuttering of the US mission in Chengdu. And that’s to say nothing of Mike Pompeo’s abrasive speech in California and visa fraud charges leveled against a handful of Chinese researchers.

Deutsche’s Ruskin offers the following color on spiraling tensions between the world’s two largest economies:

What has amplified USD worries is that the so called US — China decoupling will also act to undermine the USD’s reserve status. In the same way as both the US and China are trying to curtail interdependence when it comes to technologies; natural resources; and now medical supplies, so China will likely strive for independence from the USD’s dominant role as an international means of exchange. This encroaching challenge to the USD’s ‘medium of exchange’ status, is interlinked but different from the worries about the USD’s ‘store of value’. The latter is usually where worries about the USD’s long-term reserve status are concentrated, and of course is about to be challenged by unprecedented US debt monetization.

All of this raises a number of longer-term questions, but in the short- to medium-term, traders and investors are attempting to discern whether recent weakness and the factors set out above are conducive to a rapid slide in the greenback or a kind of “glide path”.

For his part, Ruskin writes that “past experience suggests it would take a C/A deterioration of 2% of GDP or more to set in [motion] forces for a USD downside overshoot”. A smaller adjustment would entail a less dramatic downward trajectory, he says.

For me (and likely for most readers), the larger question around the dollar’s long-term viability as the world’s preferred medium of exchange and default vehicle for savings is far more interesting, at least as a subject for discussion and debate.

As ever, I’m skeptical of the notion that the dollar will lose its reserve currency status at any point in my lifetime. To adapt a great Harley Bassman quotable, “I am certain of the denouement, but it is possible its date is vastly longer than my career”.

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