A US dollar devaluation would have an impact on movements in other asset classes. As of late 2019, currency volatility is among the lowest it’s ever been with central banks currently supportive of markets, helping to dampen volatility.
Here’s the G-7 FX 1-month volatility index:
(Source: Refinitiv data stream)
However, when interest rates become low to the point where they can’t be lowered anymore and relative interest rates between countries can’t be changed, currency volatility must necessarily pick up.
The inability to lower interest rates much is true in all developed markets.
Japan’s rates are at zero or negative along almost the entire curve. The same is true in Germany, Switzerland, France, and other developed European markets. The US isn’t far behind.
In other words, when interest rates become tapped out, currencies will undergo pressure to depreciate. Otherwise these moves will translate into economic volatility, which is less desirable.
For example, Greece was pegged to the euro during its debt crisis in 2012. Accordingly, it wasn’t able to pursue an independent monetary policy, so had to take the devaluation internally through lower output and incomes. If it had been on the drachma, which was officially phased out in 2002 (and had been pegged to the euro during the transition period starting in June 2000), it could have better handled its debt issues by lowering the interest rates, extending out the maturities, and devaluing its currency.
Due to the US’s balance of payments deficits (i.e., current account deficit, fiscal deficit) and bloated net external debt to GDP ratio (about 45 percent), the dollar will eventually need to depreciate.
A weaker currency helps create debt relief – foreign borrowers get paid back in money that’s less valuable – and helps make exported goods more competitive internationally. A cheaper currency (lower relative exchange rates) is effectively the same as giving a discount to buyers.
In the US, currency policy is within the purview of the Treasury Department. The Trump administration hasn’t explicitly stated a desire over where it wants the currency to go, through Trump has railed against a stronger dollar multiple times, and has even considered direct intervention. However, the Treasury likely lacks the resources to exert much of an effect on the greenback and has not acted on intervening.
But more generally, when the rates and fixed-income channel for conducting monetary policy is exhausted – i.e., rates are zero or negative and yields further out along the curve are zero or negative – then “currency wars” are likely to become more prominent. There is increased pressure on governments to depreciate their currencies.
Pegged exchange rate systems are at increased pressure of folding or being altered when they are inconsistent with the underlying macroeconomic fundamentals. There is increased currency risk for traders, who currently perceive currency risk to be around all-time lows.
Moreover, since exchange rate depreciations provide no real net value-add, exchange rate shifts will not bring about the global easing that will help improve asset prices and living standards on a global (though can on a country-specific level if they can reduce exchange rates in relative terms, notably with respect to key trading partners).
When exchange rates move, that benefits one country at the expense of another. There are also distributional effects. If you are a net borrower, a weaker currency is typically helpful, as you pay back in depreciated currency. If you are a net creditor, a weaker currency is a disadvantage, as the asset you held (somebody else’s debt) is now worth less.
Let’s go through a rundown of how a US dollar devaluation would impact various asset classes.
Equities generally negatively correlate with the USD. Over the past 12-13 years, the S&P 500 and the dollar index have held a slight negative correlation (minus-0.21).
However, correlations are not stable over time and it’s more important to understand the cause-effect relationships.
A few as it pertains to the dollar / US equities relationship.
1. A lower exchange rate relative to US trade partners helps firms that rely on selling their goods abroad. Because most of the largest US companies sell goods and services internationally, a lower dollar is generally beneficial to earnings.
US small cap stocks tend to do more of their business domestically and have less foreign sales exposure. Accordingly, they generally don’t benefit as much from a weaker dollar to the same extent as multinational corporations do.
2. USD strength can be a sign of broader strength of the US economy. This can also support the outperformance of US equities relative to foreign-facing companies.
3. A US intervention to weaken the USD could cause an increase in geopolitical risk and market volatility. Markets typically react to volatility by pricing equities lower.
Impact on Chinese and emerging market equities
A weaker US dollar relative to other currencies would bring about a global easing. Emerging market equities would be expected to benefit as a whole.
Most foreign external debt (roughly 65 percent) is priced in USD. A cheaper dollar would make this debt easier to pay back. Many commodities are also priced in USD. These would become cheaper to many commodity importers.
Most of the world imports commodities from a smaller number of exporters. So, in terms of the distributional effects, this would be net positive for most countries purely from a commodities pricing standpoint.
This would also place less pressure on Chinese capital outflows, which would also be a plus for Chinese equities.
However, at the same time, it depends on the nature of the depreciation. If the fall in the USD causes growth headwinds to other countries because their currencies become too strong, this could ultimately become a more important driver of the returns of EM equities.
While the USD is somewhat overvalued relative to long-run expectations – evidenced by its high net external debt and bloated fiscal and current account deficits – the size of the depreciation has to be balanced in a way that’s not too large or small to give the desired effect.
Over time we can see that EM equities have had a noticeable negative correlation with the dollar, primarily through the channel of cheaper USD debt and cheaper commodity imports.
Emerging market credit
EM credit has typically traded inversely with the US dollar. Namely, its price has increased during periods of USD depreciation.
Some of it is chicken-egg in nature. When the world is in a synchronized global upswing, there is less demand for the safety and liquidity of safe haven currencies, such as the USD, JPY, CHF, and/or gold. More gets pushed into EM financial assets where higher returns are likely to be had and less into the traditional safe markets.
So, while there is some causation involved in a weaker dollar and stronger EM assets, some of the relationship is a matter of basic flows and the reality that all assets compete with each other.
Developed market FX
A US dollar devaluation is likely to be met with devaluations by other countries mired in their own low-growth, low-inflation environments.
In developed markets, the US has more monetary policy room than other countries to boost the economy. The Fed still has 155bps at the front end of the curve and 230bps at the back end. In Japan and most of developed Europe, they are at the point at which they’re more or less tapped out on the rates and fixed-income front to stimulate their economies.
Given the zero-sum nature of FX devaluations, a US depreciation likely wouldn’t simply slide by other countries to avoid a tightening in their own financial conditions. So, USD intervention would very likely be met by intervention by the BOJ, ECB, and Swiss National Bank at a minimum, all of whom don’t want stronger currencies.
A currency depreciation is inflationary holding all else equal. Your currency doesn’t go as far, so the relative prices for imports increases. And if imports are more expensive, then the demand for local goods will be higher, increasing their prices.
If inflation increases, then you would normally think that bond yields would increase because bond yields are simply a function of:
- the real risk-free rate,
- credit premium (i.e., to reflect credit risk), and
- inflation and inflation expectations
However, currency depreciations are often motivated by disinflationary or deflationary forces, such as having too much debt, which puts more capital into debt servicing and away from consumption and investment.
So, when currency devaluations happen, you often don’t see bond yields increase (i.e., bond prices fall). That comes later, because since you’re counteracting deflation, not much in the way of inflation is produced.
In the US during the Great Depression, they added money into the system (because there was too much debt and not enough money to service it). This devalued the dollar because of an increased supply. Gold went up because gold typically tracks the quantity of currency and reserves in the system globally. Long-term bond yields continued to fall because investors still wanted safety and liquidity and could get this through Treasury bonds.
In other words, just because the dollar loses its value doesn’t mean that the bonds will be bad. Even though the typical reaction to a currency depreciation is for bonds to sell off at first – i.e., stimulative to economy and inherently inflationary, so more inflows into risk assets – in a scenario where currency devaluations are used to counteract deflation and the depreciation doesn’t get them very far in negating it, bonds often continue to increase in price.
Major European bond markets are already more tapped out than US bond markets. We’ve seen some European yields get down to minus-100bps, but there’s a limit to how negative yields can get. At some point, you’re going to force creditors out of safe assets and into riskier assets if they’re simply losing money.
A US dollar devaluation would make US exports cheaper in relative terms and euro zone exports more expensive. This could dampen euro area growth expectations and cause some level of inflows into safe European bonds.