After shedding all of this year’s gains during an autumn retreat, the US dollar, as benchmarked by the trade-weighted DXY basket, or ‘Dixie’ index, stands no higher now than it did in spring 2022. Investors must assess why the globe’s reserve currency is sliding, whether those trends will continue and what would be the potential implications for investment portfolios should the greenback continue to weaken.

HIGHWAY TO HELL

There are three potential explanations for the dollar’s weakness. The first is that the US Federal Reserve is done with raising interest rates and is primed to cut them in 2024, after the gallop to 5.50% in July from 0.25% in February 2022. Whether this is in response to lower inflation or economic weakness remains to be seen.

The second is the ballooning US budget deficit. Some are already arguing that a return to QE (quantitative easing) is one possible way out, to monetise the $33 trillion (and growing) Federal debt and artificially suppress bond yields and interest rates, at the same time increasing the supply of dollars and lowering the return on holding them.

There is no sign of this yet, but the US Treasury is clearly aware of the dangers. It has shifted to issuing short-term treasury bills (and away from long-term treasuries) to fund the US government’s insatiable funding needs. It may be expedient, because the alternatives are higher taxes, spending cuts or higher treasury yields to drum up demand for long-term bonds, but it is a bad look, one that is straight from emerging markets and that is inherently inflationary, given the lack of fiscal discipline involved.

The Treasury is aiming to meet nearly 60% of this quarter’s funding needs with short-term bills, rather than the usual 15% to 20%. Inflation means loss of purchasing power and a less attractive currency.

The third is that non-US central banks are diversifying their foreign exchange reserves away from America’s currency, because of their concerns over America’s federal deficit and future supply of bills, Treasuries and thus dollars. The International Monetary Fund’s latest quarterly Composition of Official Foreign Exchange Reserves (COFER) report confirms the long-term trend away from dollar holdings. As of September 2023, the dollar represented 59% of global exchange reserves, only a fraction above December’s 2021’s 25-year low and way down from this century’s 73% peak, back in 2001. The DXY is higher now than it was then, so loss of value is not the reason, either.

Over the past two decades, the euro has made its presence felt (nearly 20% of all forex reserves), as has the Chinese renminbi, but the latter is barely 3% of allocated forex reserves even now, and Beijing’s tight control of its currency is just one reason why it is not going to replace the dollar as the globe’s reserve currency any time soon.

As such, any ‘demise of the dollar’ narrative should not be overplayed, not least given the lack of credible alternatives, but investors need to assess whether any of the three above trends will become entrenched, given the potential implications for portfolios.

BACK IN BLACK

Two asset classes in particular look sensitive to the dollar. The first is commodities. All major raw materials, except cocoa (which trades in sterling) are priced in dollars. If the US currency rises then that makes them more expensive to buy for those nations whose currency is not the dollar or is not pegged to it and that can dampen demand, or so the theory goes. While the past is by no means a guarantee for the future, it can be argued that there is an inverse relationship between the DXY and commodity prices.

The second is emerging equity markets. They do not appear to welcome a strong dollar either, judging by the inverse relationship which seems to exist between the DXY and MSCI Emerging Markets (EM) benchmarks. Dollar strength at the very least coincided with major swoons in EM, or at least periods of marked underperformance relative to developed markets, during 1995-2000 and 2012-15. Retreats in the greenback, by contrast, appeared to give impetus to emerging equity arenas in 2003-07, 2009-12 and 2017-18.

This also makes sense, in that many emerging (and frontier) nations borrow in dollars and weakness in their currency relative to the American one makes it more expensive to pay the coupons and eventually repay the original loans.

Dollar weakness could therefore mean a resurgence in interest in two downtrodden asset classes, especially commodities. Should the American reliance on short-term T-bill funding lead to a second upward leg in inflation, then investors may look for stores of value where supply grows slowly in absolute terms, or at least relative to potentially rapid increases in the supply of fiat currency.

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