Travel broadens the mind, they say. In my case, a recent tour of Germany, France, Belgium and the UK, attending client events and one-on-ones, has given me a valuable new insight that I would like to share with you now: Whatever the dollar does, we won’t like it.
Talking with clients, many questions that come up have a rather local perspective, understandably. But one of the most consistent concerns among clients everywhere I’ve visited lately is the weakness of the US dollar.
The dollar’s fate has also started to concern European decision-makers. In a flight of rhetorical gymnastics at which he is becoming increasingly adept, Jean-Claude Trichet, the European Central Bank President, stated, “I trust that it is extremely important that the US authorities […] will pursue policies that are taking into account the fact that the strong dollar is in the interest of the United States of America.”
After recovering from the whiplash induced by this gem of central-banker-speak, we note that it positions not one but two big elephants in the room. The first is that, without US dollar weakness, the global imbalances that led us, over decades, to where we are today will likely not diminish. The world simply cannot satisfy its growth ambitions by endlessly exporting to the US. Obviously, China comes to mind here as it is unwilling to let its currency appreciate against the dollar; but at least the Chinese authorities have boosted domestic consumption demand quite a bit, which can hardly be said of many European countries.
The second awkward truth is, in our view, the real cause of US dollar weakness today. Here, we must be careful not to mix the long term with short term. While it is true that the lax fiscal and monetary policies the US is currently practicing will likely keep the dollar on a depreciation trend, policies are not eroding the greenback today. Rather, it is the dollar’s role as the preferred funding currency for carry-trades – the investment strategy that calls for taking on debt in a low-yielding currency and buying assets in a high-yielding one – that is the immediate cause of the greenback’s weakness. The Fed’s commitment to prolonging low interest rates has made the US dollar even more attractive than the Japanese yen in carry trades now.
One lesson from the financial crisis is that carry trade activity is closely correlated with equity markets. If equities rally, carry trades also pick up; and if they correct, carry trades sputter. This leads me to recall another useful insight: be careful what you wish for; it might just come true. In this case, a stronger dollar could ultimately mean that stock markets are losing steam, a development that few would welcome.
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