Commentary: Stop Bashing the Buck

The increase in investors’ risk appetite weighed on the value of the dollar during the second quarter. There was a sharp 20% appreciation against other major currencies over the 12 months ended in March when investors sought a safe haven from the financial storm. Since then, it’s given up about half its gains. We think the greenback will stabilize near its current level and gain a bit of ground in the months ahead, despite concerns about the inflation outlook and an explosion in Treasury debt issuance.

In the near term, the dollar should be helped by the relative strength of the U.S. economy, as it appears to be closer to recovery than the economies of most other developed nations. Consensus forecasts call for the year-to-year decline in U.S. industrial production to bottom out in the second quarter at 12.6%. That’s an awful performance, to be sure, but far better than the 30% plunge in Japan or the 19% contraction in Germany over the same period. We also note that inflation and interest-rate differentials are either neutral or somewhat favorable for dollar appreciation at this time. On a purchasing power parity basis, the dollar appears modestly undervalued.

We strongly disagree with those who envision a dollar collapse resulting from the sharp increase in Treasury debt issuance and the ballooning of the Federal Reserve’s balance sheet. In our opinion, deficit spending and aggressive monetary easing have been appropriate responses to the crisis, preventing an even steeper downturn (and the associated revenue drain from the government’s coffers) than might have otherwise occurred. Although Treasury bond rates have risen meaningfully off their March lows, we believe this is more a reflection of the normalization of financial markets than a sign that investors are choking on debt. On the contrary, recent Treasury auctions have been quite strong, contradicting the pessimistic view that the world cannot absorb the increase in supply.

It also should be pointed out that a sharp rise in the deficit does not automatically lead to a slumping currency. Exhibit 1 on the following page shows that, in the early 1980s, the U.S. budget deficit climbed from 1% of GDP to a high of 5.5%. The dollar nevertheless increased 50% in value between 1980 and 1985. To be sure, inflation-adjusted interest rates in the U.S. rose dramatically during this period, but much of that gain reflected a sharp decline in the inflation rate that was not anticipated by investors. There’s an echo of that now. Real interest-rate differentials have moved sharply in favor of the U.S. in the past year against the euro zone, Japan and Canada. Although nominal short-term rates have fallen in the U.S., rates have slumped more elsewhere (the UK being a notable exception). The shift from inflation to deflation, meanwhile, has been sharper in the U.S. than in other developed countries. While a 1980s-style surge in the value of the dollar from these levels may not be in the cards, we think the currency will hold up better than many observers expect.

Exhibit 1: Federal Budget Balance vs. Trade-Weighted Dollar

Sources: Bureau of Economic Analysis, U.S. Treasury, Federal Reserve Board, SEI
(Click image to enlarge image)

Recent talk about substituting the Special Drawing Rights (SDRs)¹ of the International Monetary Fund (IMF) for the dollar as the world’s reserve currency has generated additional pessimism. This may be a legitimate concern but only in the very long run measured in decades. Almost two-thirds of the world’s official foreign exchange reserves are denominated in dollars, as seen in Exhibit 2 on the following page, and nearly 90% of daily foreign exchange trading involves U.S. dollars. At the G-20 summit in London this past April, participants agreed to increase the IMF’s issuance of SDRs by $250 billion; that raises its share of total international reserves to only 4%. The logistics of a root-and- branch reform of the international trading system are formidable, politically and economically.

Importantly, one of the most vocal proponents of currency reform – China – would find the transition extremely problematic. In order to raise the profile of the renminbi, China would need to ease capital controls and make its currency fully convertible. The country would also need to let its currency appreciate significantly against the dollar, something it has been loath to do. Not only would there be a negative wealth effect as its dollar-denominated assets drop in value, but it would also face a decline in export competitiveness.

Exhibit 2: Currency Composition of Official Foreign Exchange Reserves

 
Sources: International Monetary Fund, European Central Bank, SEI
(Click image to enlarge)

While history has shown that having reserve-currency status is not an immutable right, a prolonged period of economic and military decline usually precedes a change of monetary regime. Economic historians often draw parallels between today’s rivalry between the U.S. and China with that of the U.S. and Great Britain in the late 1800s and early 1900s. However, it took two world wars and the Great Depression before the U.S. assumed its predominant position in a new monetary order. Its current economic woes notwithstanding, the U.S. is hardly in the throes of collapse. On the contrary, when the global economy went into freefall last year, the dollar soared as investors sought the safest and most liquid place to put their money. Sir Winston Churchill famously said, “Democracy is the worst form of government, except for all those other forms tried from time to time.” The same can be said for the dollar as the world’s reserve currency. As long as fiat² currencies exist, the U.S. currency still looks to be the best of the bunch.

¹ The Special Drawing Right is an international reserve asset created by the IMF in 1969 to supplement the existing official reserves of member countries. SDRs are allocated to member countries in proportion to their IMF quotas. The SDR also serves as the unit of account for the IMF and some other international organizations. Its value is based on a basket of key international currencies, including the U.S. dollar, the euro, the Japanese yen and the British pound.

² Currency backed by an issuing government rather than by the value of a commodity, such as gold or silver.

Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Diversification may not protect against market risk. There are risks involved with investing, including loss of principal.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only.

SEI Investments Management Corporation (SIMC) is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co (SIDCO). SIMC and SIDCO are wholly-owned subsidiaries of SEI Investments Company.

To determine if the Fund(s) are an appropriate investment for you, carefully consider the Fund’s investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Fund’s prospectus, which may be obtained by calling 1-800-DIAL-SEI. Please read it carefully before investing. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors, as well as increased volatility and lower trading volume.