Published July 31, 2020
There has been a lot of attention recently about the sharp drop in the price of the U.S. dollar. This decline has sent gold and other commodity prices soaring. Driving this decline in the dollar is a quicker recovery in economies outside the U.S., last week’s coordinated stimulus action by the European Union (which bolsters the Euro), and the zero interest rate policy of the U.S. Federal Reserve for as long as the eye can see. To put this in context, until recently, the dollar enjoyed a very long run of strength as Europe and Japan struggled. While the chart below shows the dollar breaking below its trendline, this move only puts it back to where it was a couple of years ago. Nothing particularly alarming just yet. It’s simply that the view forward easily suggests this is the beginning of a new trend. We shall see.
Goldman Sachs staked out a more alarmist view to stir the discussion this week. Here is a discussion of the Goldman analysis:
“Goldman Sachs put a spotlight on the suddenly growing concern over inflation in the U.S. by issuing a bold warning Tuesday that the dollar is in danger of losing its status as the world’s reserve currency. With Congress closing in on another round of fiscal stimulus to shore up the pandemic-ravaged economy, and the Federal Reserve having already swelled its balance sheet by about $2.8 trillion this year, Goldman strategists cautioned that U.S. policy is triggering currency “debasement fears” that could end the dollar’s reign as the dominant force in global foreign-exchange markets. While that view is clearly still a minority one in most financial circles — and the Goldman analysts don’t say they believe it will necessarily happen — it captures a nervous vibe that has infiltrated the market this month: Investors worried that this money-printing will trigger inflation in years ahead have been bailing out of the dollar and piling furiously into gold.
“Gold is the currency of last resort, particularly in an environment like the current one where governments are debasing their fiat currencies and pushing real interest rates to all-time lows,” wrote Goldman strategists including Jeffrey Currie. There are now, they said, “real concerns around the longevity of the U.S. dollar as a reserve currency.”
The Goldman report makes clear that Wall Street’s initial reluctance to sound the alarm on inflation back when the pandemic began is fading. Having been burned badly by ominous forecasts of runaway price gains following the 2008 financial crisis, many analysts have been hesitant to repeat such calls now, especially as the economy sinks into a deep recession. But with gold surging to record highs and bond investors’ inflation expectations climbing almost daily, albeit from very low levels, the debate on the long-term effects of stimulus has gotten louder.
The 10-year break-even rate, the gap between nominal and inflation-linked debt yields, has risen to about 1.51%, up from as low as 0.47% in March. That’s seen real yields, which strip out the impact of inflation, plunge further below zero — to about -0.93% on similar-maturity bonds. Adding to the upward pressure on inflation expectations are forecasts that the Fed will soon link guidance on the policy rate to prices. That would provide at least some temporary space for inflation to run above the central bank’s 2% target.
“The resulting expanded balance sheets and vast money creation spurs currency debasement fears,” the analysts at Goldman wrote. This creates “a greater likelihood that at some time in the future, after economic activity has normalized, there will be incentives for central banks and governments to allow inflation to drift higher to reduce (effectively write down) the accumulated debt burden,” they said.
Gold’s record-breaking rally highlights growing concern over the world economy. Goldman raised its 12-month forecast for gold to $2300 an ounce from $2000 an ounce previously. That compares with a value of around $1950 currently. The bank sees U.S. real interest rates continuing to drift lower, boosting gold further.
Meanwhile, the Bloomberg Dollar Spot Index is on course for its worst July in a decade. The drop comes amid renewed calls for the dollar’s demise following a game-changing rescue package from the European Union deal, which spurred the euro and will lead to jointly issued debt. Of course, people have been wrong-footed in calling for the dollar’s demise for years — including when the Fed was aggressively easing in the wake of the 2008 crisis.
The ICE U.S. Dollar Index hasn’t had more than three consecutive years of annual declines since the early 1970s. That’s in part because there are few viable alternatives to dollar assets such as Treasuries, the world’s biggest bond market with nearly $20 trillion outstanding. The dollar is used in 88% of all currency trades, according to the latest triennial Bank for International Settlements survey. And it still accounts for about 62% of the world’s foreign-exchange reserves, although that’s down from a peak of more than 85% in the 1970s, IMF data show. The U.S. “isn’t anywhere close to losing its reserve currency status given the depth of capital markets and overwhelming volume of U.S. dollar-denominated global transactions,” said Michael Krupkin, head of G-10 FX spot trading for the Americas, at Barclays Plc.
For Goldman, the growing level of debt in the U.S. — which now exceeds 80% of the nation’s gross domestic product — and elsewhere, boosts the risk that central banks and governments may allow inflation to accelerate.”
Another firm pointed to how dollar weakness would shift the investment landscape toward international stocks.
“In a note to clients last week, Gavkeal Research’s Louis Gave wrote that “the dam is now starting to break for the dollar. And as it breaks, this has the potential to unleash a dramatically different investment environment than the one that prevailed in the past decade.”
A strong dollar has drawn capital from elsewhere, bolstering U.S. large-cap tech stocks, which in turn led to additional dollar buying, and posed a challenge for emerging markets. A weak dollar could unwind some of that and usher in a wave of growth among less developed economies.”
While large-cap tech stocks show no signs of letting up, the stock market does appear to be widening in its scope. That is a positive for the stock market. The declining U.S. dollar is helping to further that breadth.
Market Update
A topsy-turvy week for stocks punctuated by a Fed meeting, earnings from most of the market leaders, and the tug-of-war in Congress over another round of stimulus payments. Monday brought a +0.7% gain on optimism for those large-cap tech/consumer earnings. However, weak earnings reports Tuesday from 3M (MMM) and McDonalds (MCD) led stocks to reverse Monday’s gains. The Fed performed its magic Wednesday, reminding investors that interest rates will remain near zero and the central bank continues to be ready to provide any support necessary. Stocks popped +1.2% higher on the comforting words. They slipped back -0.4% Thursday ahead of earnings reports from the market’s heavy hitters after the close. The report on Q2 GDP (no surprise: a precipitous fall) kept the mood cloudy while strong earnings from a couple of benefactors of online shopping – UPS and PayPal (PYPL) – offered a lift. The market leaders did not disappoint, crushing earnings estimates. Amazon (AMZN), Facebook (FB), and Apple (AAPL) all soared on the reports, leading the Nasdaq 100 (QQQ) up by +1.5% Friday. Stocks were held back a bit by sour earnings from Chevron (CVX) and Caterpillar (CAT) and the stalemate in Congress over the next round of pandemic support/stimulus.
The S&P 500 rose +1.76% this week, holding above the 3200 level. The Nasdaq 100 (QQQ) reaffirmed its leadership with a +4.00% rise on powerhouse earnings from its largest components. Small-caps were the most impacted by the Congressional slog and a further decline in interest rates. The small-cap index (IWM) managed a lesser +0.88% move.
Warm wishes and until next week.