USD bears celebrate Blue Wave Lite, but what about rates?

That brings us to the potential spoiler for an easy path lower for the US dollar, despite the compelling fundamentals for the USD bearish case noted above: a steepening yield curve and a further rise in US long yields, which broke higher above key thresholds – like 1.00% for the US 10-year Treasury benchmark – in the first week of 2021. All other things equal, higher yields are a form of tightening of financial conditions, and globally so as the USD is the reserve currency. Sure, this can reflect better optimism about the economic outlook, but given the enormous further growth in debt from the Covid-19 response, the level at which higher rates become a problem has dropped sharply just as it has for every cycle since the 1980s. Recall that by late 2018, a 3.0+% US 10-year yield and a tapering Fed with its 2-2.25% policy rate virtually broke financial markets and forced the Fed to reverse course. On top of that, global markets by the end of 2020 had lurched into a speculative frenzy in some corners of the market, and higher yields would erode the justification for sky-high multiples of the most popular and speculative growth companies. 

Whether the level that gets markets into trouble is 1.25% or above 1.50% in the US 10-year benchmark, trouble lurks…unless the Fed does what it has hinted its next policy might be if rates rise before labour markets have normalised: yield curve control, or effectively, capping longer treasury yields. It’s certainly possible, but the Fed may have a hard time rolling out yield caps or “yield curve control”, if sharply rising price pressures begin to show up in a rapidly recovering economy and improving labour market conditions. In short, asset market volatility becomes an accelerating risk with every tick higher in long yields; would the Fed risk the turmoil of a yield curve control move with financial market conditions easier than they have ever been? The smoothness of the greenback’s descent in Q4 may not repeat in Q1.

In the Goldilocks scenario for USD bears from here, US yield rises will prove muted and EM and commodity currencies will continue to put in a stellar performance on normalisation as the weather warms and vaccines are administered at high volumes. From a valuation and carry perspective the Turkish lira is compelling if Turkey can avoid geopolitical quagmires. Other winners in a reflationary recovery could include the South African rand and Russian ruble, although geopolitics are a very prominent risk for the latter under a US President Biden. Within the G-10, the commodity currencies are less compelling than they were before their recent blistering ascent, although they should do fine in a reflationary recovery. Also, there is still value in NOK if oil prices continue to normalise. In G3, besides the extensive USD coverage above, the euro benefits from global growth normalisation on the export side, but is dragged by less generous domestic stimulus and a negative policy rate, while the JPY hates higher yields and tends to track the US dollar in the crosses. Sterling is a tough call: structurally, there are the same negatives as for the USD, but its valuation is in a completely different post code – so its ceiling may prove somewhat low in a recovering economy.

Biggest global monetary shift in several generations under way?

Longer term, the key challenge for the US dollar could become downright existential if the world begins to lose trust in the “faith and credit” of the US Treasury. This challenge could come from two directions. The first of these would be the prospect of negative real interest rates, in which overuse of the printing press on the fiscal side results in high inflation that is not sufficiently offset by the policy rate – say 4% inflation with a 1% Fed Funds rate. The rise in gold, bitcoin/crypto assets, hard assets of any kind and the sudden increase in monetary velocity caused by an exodus from USD-linked former risk-free assets like T-bills and treasuries, could theoretically even trigger an outright USD crisis. 

Secondly, there is the challenge to the US dollar as the sole real global reserve currency in the shape of a China that is looking to replace the US dollar in its trade relationships with the outside world. It’s doing this both as a means of attracting global capital as it has achieved the status of global power on a par with the Euro bloc and the US, but also to avoid vulnerabilities to its financial system if the US weaponises the US dollar and its effective control of the global financial system in an attempt to thwart China’s rise, given that the rivalry between the two powers will only escalate from here. The instrument with which China is attempting this transformation of the renminbi to global currency status is the DCEP, the Digital Currency Electronic Payment framework or “digital yuan”. Already in trial runs in parts of China, the DCEP will be pivotal in its so-called dual circulation policy of maximising domestic growth while continuing to open its economy and capital markets to the world. A successful rollout of the DCEP in coming years could be the most momentous change to the global monetary system since the Bretton Woods system was created back in the dying days of WWII at Bretton Woods.