Various scenarios for the US dollar

>> What if the FED won’t be able to cut rates?

Now we don’t doubt that this sort of scenario could produce a modest rise in the US dollar. But, on the other side, if US “exceptionalism” falters and the Fed moves fast to cut, the downside for the US dollar could be far more significant than the upside targets under the consensus scenario.

There’s a lot of talk about US exceptionalism. For instance, the IMF recently revised up its estimate for GDP growth this year to 2.7%; double the pace of any of its G7 peers. This exceptionalism has so far produced a modest rise in the US dollar against other developed currencies, not a dramatic one and we think the reason for this is that the US has to be exceptional. Why do we say this?

The point we would make is that the US needs to suck in foreign capital because this exceptionalism is depleting domestic savings. Hence, if the US wants to invest, to be exceptional, it needs foreign capital. At the moment, the ratio of net savings (which is the combined savings of households, firms and the public sector) to GDP is zero. Before the pandemic, it was over 3% of GDP and it has come all the way down from over 12% back in the 1960s. Provided the US is seen as exceptional, by offering the prospect of stronger stock market performance, or by offering higher bond yields than its peers, then these savings will flow in.

In fact, too many might flow in, putting upward pressure on the US dollar. By and large, that’s what we’ve seen. US stocks have outperformed, US yields have been higher than elsewhere, and the US dollar has risen. In some senses, it would appear to be a perfectly good, or “equilibrium” position: the US gets the capital it needs to be exceptional, and the rest of the world benefits from both the earnings investors make on US assets and the help to trade that comes from a weaker domestic currency against the dollar. But in fact, it might be anything but an equilibrium situation because the US has borrowed too much and the US dollar has risen too far.

>> Factors drive the US dollar

If, for whatever reason, this exceptionalism wanes, the US dollar could find itself in a very vulnerable position. One reason for this vulnerability will be because expectations concerning Fed policy will flip back in favour of much more aggressive rate cuts than those presently priced into the curve. But it also runs much deeper than this. One reason we say this is because the US seems to have been busy cutting off these sources of inward investment. Whether that be from imposing tariffs on China, or blocking countries from using dollar-based payment systems and freezing reserves, such as Russia.

Steve Barrow, Head of the Standard Bank G10 Strategy, said another issue is that the bulk of the deterioration in US net savings is coming from the public sector, not firms and households. The problem here is that the government is finding it hard, if not impossible, to reverse this process, which is why there’s concern that the US could eventually end up in a debt crisis. If the dissaving was in the private sector, there would be a better chance of correction if the dissaving became excessive. Yet another issue is that US exceptionalism could push the US dollar to untenable levels, eventually making US assets too expensive for even the most bullish overseas investor. And if this does not turn the US dollar around “naturally”, central banks may have to try to do the job with intervention, as some, such as the BoJ have done.

“Don’t get us wrong. We are not saying that the US dollar is on the edge of a huge precipice because US exceptionalism is about to end, or that central banks are about to act together to try to bring the US dollar down. All we are pointing out is that there’s a lot invested in the base case scenario of US exceptionalism, Fed delay and US dollar strength. And yes, as we said at the start, this scenario can produce a modest rise in the US dollar. But the risk of a really big move lies on the other side if perceptions develop that the US is not so exceptional, the Fed needs to cut fast, and that the US dollar is badly priced for this alternative scenario”, said Steve Barrow.