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Quarterly Outlook: World turning its back on the almighty dollar

John J Hardy
   • USD an 'increasingly dysfunctional' global reserve currency
   • 'Easy monetary policy is a poor tool for stimulating demand'
   • 'Q4 has to be the quarter that the UK turns the corner on Brexit'

John Hardy
By John J Hardy

Generational geopolitical shifts point to an urgent need to replace the US dollar, the increasingly dysfunctional global reserve currency, with “something else”. Finding out what that something else will prove to be is the single most important tectonic shift for global markets in coming years. 

But as a backdrop, let us first consider three geopolitical drivers that put direct and indirect pressure on the US dollar’s role in the global economy: 

  • The ongoing rise of China as it assumes a more prominent role in global trade and financial markets and in particular how it will manage policy and unwinding the excesses of its credit bubble in the wake of the 19th Party Congress scheduled for October 2017 without upsetting its domestic economy and the global economy. 
  • The North Korean regimes' striving to maintain credibility and untouchability as a nuclear power and how this impacts China-US relations, but also how Japan deals with this threat in terms of domestic as well as foreign policy. 
  • The loosening of the US-Europe transatlantic alliance and how Europe and the European Union finds its feet as a more independent superpower – or not – in its own right after the German elections. 

From these three regional drivers, we can extract two critical global themes for what could drive notable moves in the major currencies from here: first, dedollarisation and second, the fiscal impulse. 

For the latter, we mean the potential for a transition away from focusing on monetary policy acting in isolation to policies driving fiscal expansion, with the central bank serving merely as an auxiliary. The popular term is "helicopter money".

The fiscal impulse and links to geopolitics

It has been an open secret for years now that extraordinarily easy monetary policy is a poor tool for stimulating demand in an economy. It works to an extent to prevent an immediate credit crunch, but the longer-term unhealthy side effects have become painfully clear. 

The benefits of negative interest-rate policy (NIRP), zero interest-rate policy (ZIRP), and quantitative easing (QE) accrue chiefly to the already wealthy as the low cost of carrying and issuing debt rewards debtors and the already creditworthy who can take on additional debt. 

Rewarding the already wealthy is a weak route to economic growth as the wealthy have a low propensity to spend additional gains.

Meanwhile, new entrants into the economy are faced with high barriers to participating in the upswing in asset prices. They are left, for example, unable to save enough for a down payment for a house due to runaway price gains in real estate. Furthermore, central banks’ mispricing of money crushes productivity as inferior economic performers can continue operations with cheap debt and staggering debt loads rather than being forced out of business. 

The non-existent productivity growth and the “distributional effects”, a euphemism for the egregious inequality that the era of NIRP and ZIRP and QE has created, have brought us populism in the form of Brexit and President Trump.

In policy terms, the rise of populism and imbalances of inequality will mean that the policy response from here will change. Rather than more of the same from central banks, we will look for the next round of economic weakness – and we see one dead ahead on the weakening of the credit impulse – to see a shift towards fiscal solutions.
Weaving this into our geopolitical story, we see the potential for fiscal stimulus even to run ahead of the inevitable response to an eventual economic recession. The two entities most likely to see notable fiscal stimulus in the quarters ahead are Japan and the EU. 

In Japan, the combination of the country’s pacifist constitution and the intolerable threat of a nuclear North Korea has already led prime minister Shinzo Abe to call snap Lower House elections for October, seeking, among other things, a renewed mandate for his tough attitude towards his unpredictable neighbour. He plans also to rebalance Japan’s social security system to address Japan’s rapidly-aging population and childcare. 

Crucially, he has ordered officials to prepare a ¥2 trillion ($17.8bn) fiscal stimulus package by year-end. The JPY could firm a bit on this fiscal impulse, especially as some of the focus will be on domestically oriented investment, decreasing some of the savings flow to foreign shores. 

At some point, inflation might even show a pulse and allow the BoJ to takes its lead foot off the monetary gas pedal, though it is far too early to see a tapping of the brakes.

In Europe, the dynamics also point to a potential for fiscal expansion in the wake of the German election as chancellor Angela Merkel and French president Emmanuel Macron move to reform the EU to avert the long-term risks of populism, as evidenced in the strong showing of the far-left and far-right in elections across the EU. 

The initial focus for stimulus will likely be on defence due to the increasingly outdated Nato alliance and a wobbling US ally as the focus of US policy risks turning inwards. The common defence is the perfect initial excuse for the creation of mutualised debt, a needed step if the EU is to move toward fiscal union.

Geopolitics, China, and dedollarisation

As the world’s largest economy and owner of the world’s global reserve currency, the US has, for better or worse, lived beyond its means as it exported currency to the rest of the world in the form of treasury debt. Now, a rising China is eyeing the benefits of having its own currency play a larger role and to supplant the USD’s role in global trade. 

The initial focus is on the global oil trade, where there is rising anticipation of a yuan-denominated oil future to be listed in Shanghai, and the possibility that China will express an intention to transact oil imports in yuan. Such a move would increasingly shift global trade in oil, the world’s largest single traded product, off of the US dollar and allow China to reduce its massive USD reserves, especially if the use of yuan is spread to other areas of trade. China is now the world’s large oil importer. And if China, having built massive gold reserves in recent years, allows any trade partner to exchange their yuan revenues from oil directly into gold, it would likely vastly reduce the interest in holding foreign exchange reserves in US dollars, increasing the interest in holding gold and yuan. 

China is the world’s largest oil importer and a successful transition to transacting oil in yuan and maintaining a stable currency would be the first key steps towards the long-term deepening of Chinese capital markets and importing global demand for its currency. 

Such a move would aid China’s needed rebalancing away from excessive savings (and therefore investment) and toward more consumption. Important oil exporters Russia and Iran, long suffering at the hands of US financial and trade sanctions, will be happy participants in this scheme and could provide critical mass. 

The bigger test will be whether traditional US allies, such as Saudi Arabia, would be willing to risk the ire and financial might of the US by agreeing to receive yuan for oil. 

There are certainly risks to the approach, though the wind is at China’s back.

There is another compelling angle to this and that is China’s need to devalue its way out of the excesses of the credit bubble it has so dramatically inflated, particularly since the global financial crisis. The argument in recent years has been that China must devalue its currency against global peers – but doing so would spoil the plans outlined above to raise the renminbi’s profile and encourage trust in China-bound investment. Instead, perhaps China’s gambit is to export the needed devaluation to the global economy by devaluing against commodities like gold and oil rather than other currencies. In any case, China is strategically committed to currency stability and will do whatever it can to drive devaluation by other means.

More specifically for Q4 of this year, we offer our thoughts on the direction for the G-10 currencies:

  • USD: the US dollar’s slide is set to continue, though we may not see a one- way slide in Q4 that has characterised much of this year. Some distant echo of the “Trump trade” may finally materialise and boost the greenback at the margin as Trump and Congress eye tax reform and modest fiscal measures in 2018, but this was not the sweeping Trump trade hoped for after the 2016 election. One underappreciated USD-negative factor is the growing US budget deficit, which is only set to worsen under the Fed’s quantitative tightening – and as the US is a twin deficit nation, who will fund that deficit in a de-dollarising world in which the big old forex reserves builders in Asia and among oil exporters are not building reserves anymore – and are increasingly less willing to hold USD? 
  • EUR: the single currency is poised for further gains as the ECB heads towards a taper and points to the normalisation of policy rates and as we suspect that the EU will move to issue EU bonds, further closing the gap of peripheral spreads and encouraging the ongoing upswing in the EU economy. 
  • JPY: political developments in Japan could prove fast and furious in Q4 as Japan finds North Korean behaviour intolerable – could inflation creep back in as the USD weakens and fiscal stimulus arrives in force? The Bank of Japan can only continue with its current rate of purchase if significant helicopter money efforts lie just over the horizon. 
  • GBP: Q4 has to be the quarter that the UK turns the corner on Brexit and we start to get a clearer sense of where the process is headed. GBPUSD especially could revalue higher. 
  • CHF: if the post-German election environment continues to provide a path toward a more united EU, we see further reason for an unwind of the safe haven premium in the Swiss franc, particularly as we will see the anticipation of an ECB taper becoming active guidance on tapering plans during the quarter.
  • AUD: the Australian dollar will be an interesting proxy for whatever policy signals China sends after its 19th party Congress early in mid-October. A new fiscal impulse from China after the party Congress and a renewed interest in hard assets have to be weighed against a heavily leveraged Australian economy. 
  • CAD – the Bank of Canada’s shift to a more hawkish stance and the Canadian growth story from prime minister Justin Trudeau’s fiscal stimulus (does this provide a model for other economies?) have supported CAD dramatically, though the market may have got ahead of itself in predicting more from the BoC than from the Fed in 2018. 
  • NZD – we have long-running valuation concerns for the kiwi and the central bank has the currency in its crosshairs. 
  • SEK – the Swedish krona is too cheap, but the Riksbank wants it that way and has risked the longer-term health of the economy with absurdly accommodative policy that has driven an ugly housing bubble. 
  • NOK – potential drama for oil markets as China vies to topple the foundations of the petro-dollar. We generally like NOK’s prospects for the coming quarter.

Emerging markets

As a baseline, geopolitical confrontations and rising volatility are a distinct possible negative for emerging markets and EM currencies simply for reasons of liquidity, as investors tend to head for more liquid harbours – for example, JPY, USD and EUR – when bouts of volatility batter markets. 

But recent history seems to show that EM are less vulnerable than in cycles past and if our overall belief in a weaker USD proves correct even as volatility picks up, most EM currencies will be buy on dip prospects for carry and valuation – particularly the Russian rouble and Turkish lira.

— Edited by Michael McKenna

John J Hardy is head of FX strategy at Saxo Bank


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