Many years ago, I remember having coffee with a wizened old investment academic who gravely intoned that “David, always watch the FX markets. Everyone focuses on stock indices and bond yields, but the trouble usually starts with FX rates”. His argument was simple. As the world globalizes and becomes more interdependent, the interplay between the main currencies – the dollar, Euro, JPY and increasingly the Chinese renminbi – tells you everything you need to know about capital imbalances and the direction of the global economy. Eventually, the widely followed rates – interest rates and inflation rates – start to give us signals about those capital imbalances. Asset classes also react accordingly with commodities especially sensitive.
So, it’s with those wise words ringing in my head that we approach the elephant in the room – the weakening dollar. The chart below comes from the US Federal Reserve and shows the trade-weighted value of the dollar. Notice the direction of travel since the beginning of 2017? You guessed it – since the start of 2017, the dollar has been falling again. Inflation expectations are on the rise, slightly, as are inflation rates (compared to consumer prices during the 2015-16 downturn). Commodities are up, including WTI. And again, it doesn’t take a genius to work out why this might be happening – read the US President’s own words. Trump last year said that while a strong dollar “sounds good”, his actual view on this issue was that “our dollar is getting too strong…it is very, very hard to compete when you have a strong dollar and other countries are devaluing their currency”. The titanic battle now becomes a clash between two worldviews – weaker dollar and be damned about inflation expectations or unleashing the inflation hawks in the central banks and sharply higher interest rates. My money is on the former, especially given the fact that the new Fed chair seems a very long way from being a Paul Volcker i.e someone who will hike interest rates sharply to kill inflation dead. Which would also crush Trump’s (and the Republicans) re-election prospects.
The chart below indicates to me at least that we could see more dollar weakening to come – with a decline of another 5 to 10% on the cards. If that was the case, the asset class implications are clear. A weak dollar is bullish for oil prices – much higher oil prices could be the big surprise in 2018. And remember that every major episode of galloping inflation since 1973 has been fuelled by a surge in oil prices. Emerging market economies are also likely to benefit from a growing influx of capital as the dollar weakens. Lastly, historically at least, there is an inverse correlation between the U.S. dollar and gold.