$400bln Reasons Why the Dollar is Going Higher

5th August 2013

Macro Intelligence 2 Partners LLC is sharing influential reports that we have published throughout our time as an independent macroeconomic research company. Below is '$400bln Reasons Why the Dollar is Going Higher' from August 2013. We discuss the effects of US oil production on the current account deficit long before anyone was talking about the effects of domestic oil production. Enjoy.

I’ve just returned from ten days in Europe and it was nice to see that most clients now accept US dollar outperformance, one of my major themes since the beginning of the year. Understandably, the overriding macro justification for the view is economic outperformance and in turn, wider rate differentials. However, some of my recent work suggests that in addition to these obvious dynamics increasing energy independence has enormous structural implications for the value of the dollar. This not only suggests that the dollar’s move is still in its relative infancy but, because of its status as the global reserve currency, the rally will have profound broad market implications.   

Before we discuss the exact reasoning behind my view, it’s important to quickly examine the key dynamics of a global reserve currency. In purely economic terms, the fact that the dollar is the global reserve currency and, by default, the dominant medium of exchange for global transactions means that it’s in high demand from foreigners. This confers certain benefits on the US. The first is seigniorage from cash. This has two component; the difference the Fed earns between the physical cost of printing dollars and the value of goods or services that foreigners will exchange for them, plus the interest it earns by holding Treasury bills against the currency in circulation. The second big benefit is that, because foreigners want to hold dollar dominated debt as a store of value, US entities are, all other things being equal, able to raise funds more cheaply. However, while that all sounds lovely, it does come at a price. That’s because in order to grease the wheels of world trade and maintain a stable ratio of reserves, the US is obliged to increase both the supply of dollars as well as US debt, in line with global growth. Before the advent of the Fed’s central bank swap lines or QE that supply of dollars was generated from an ever larger current account deficit, while the debt came from the US private sector or the government building up their borrowings. So what you have is a symbiotic but inherently unstable relationship, with costs and benefits for both parties. It’s not hard to imagine how you could reach a point, where the domestic policies being pursued in the US just aren’t compatible with those necessary to support the dollar’s role as the reserve currency.  

In economics, this is referred to as Triffin’s Dilemma and for investors the key thing to understand is what causes the relationship to breakdown. If its foreigners who pull the plug as they did on Sterling, which was the reserve currency between WWI and II, or indeed on the US dollar during the Vietnam war, the reserve currency falls. This is typically inflationary, especially for the reserve nation. However, if the reserve nation fails to live up to its side of the Faustian bargain by not supplying enough currency to the rest of the world then the reserve currency rallies, which is deflationary, especially overseas. In 2008 we saw an extreme example of this when the collapse of the US private sector banking system sucked dollars from the rest of the world. However, it doesn’t have to be always so destructive, especially for the reserve nation. 

To prove this point if you look at the chart on the next page you can see Personal Consumption Expenditure (PCE), which is the measure of household consumption used to calculate GDP vs. the quarterly size of the US current account deficit since 1975. As both are in nominal terms, the lines are upwardly sloping. However, what’s interesting is that there are periods of significant divergence, which technically shouldn’t happen if US consumers had a constant marginal propensity to import, say 20% of all their consumption. So what we have are times when despite growing domestic consumption in the US, the current account deficit isn’t growing proportionately. Therefore, unless something else fills the gap, the supply of dollars to the rest of the world slows. History seems to suggest that when that occurs bad things happen, i.e. the Latin or the Asian debt crisis. Logically that makes sense because at the core of both of these crises were regions that overindulged on dollar borrowing when the buck was cheap and abundant, only to go pop when the supply of dollars fell. Indeed, back in 2008 I was extremely bullish on the dollar because I as housing slowed, US consumers would be forced to cut their spending, reducing imports and causing the current account deficit to drop. All other things being equal this would cut the supply of dollars triggering a rally, which is exactly what happened until the Fed launched QE.   

History lessons aside, what’s relevant for the current market is that despite the recovery in PCE, the current account deficit just hasn’t bounced. At this point it should be running at $200bln plus a quarter and yet is sitting at just over $100bln. We have a massive gap! Where, has that annual $400bln gone? What is causing the gap? 

The answer is simply; oil. The US consumes about 19-20mio barrels of oil a day and in 2006 about 14mio barrels of those were imported. However, thanks to increased domestic production and believe it or not improved vehicle energy efficiency, imports have fallen to around 7mio. Yes, by international standards the efficiency of the US car fleet is a joke at 24.6 miles per gallon. But that’s up 22% since 2007 and the rise will continue into 2025 when legally the average for new cars and trucks has to be 54.5 mpg more than twice current levels. That’s meaningful when you realise that 45% of our total oil usage is for personal transport. Add to that, the fact domestic oil production should, even using conservative estimates, continue to rise for the next five years, then lump in LNG exports and you can see just how a dramatically the US current account deficit could shrink.  

In dollar terms, the value of US oil imports (next page, in orange inverted) has already fallen from its peak of over $650bln prior to the crash in 2008 and have averaged $250bln over the last year i.e. a drop of $400bln annually. Interestingly, this tallies with $100bln quarterly divergence between the current account deficit and PCE suggested by the previous chart. From a market perspective what’s important is the way this change appears to correlate with the dollar’s value. Notice how from 2004 to the height of the bubble in 2008 as the US spent an ever increasing amount on oil imports, flooding the world with dollars, its trade weighted (TWI) value vs. the other major currencies (Euro, CAD, JPY, GBP, CHF, AUD, SEK) fell proportionately. This reversed very rapidly as we entered the Global Financial Crisis and because of the deflationary nature of the dollar rally, the Fed jumped in with successive rounds of QE, which worked to weaken the dollar until the other central banks joined the monetary debasement game.  

 However, it’s my firm belief that absent QE, the dollar would now be trading at a level commensurate with a bill for energy imports of around $250bln annually. Therefore, as tapering moves ahead in September (that remains the base case) the dollar’s rally should accelerate. The Fed will argue that even when they end QE, their massive $4tln plus balance sheet will mean that policy is still highly accommodative. Unfortunately, for foreigners with a short fall of around $400bln annually, this is a clear example where the flow of dollars will be more important than the stock. All other things being equal, if the dollar index closes the divergence with the oil import bill then it should trade at around 83 vs. its current level of 76 i.e. about 9% higher. Yet, as the energy bill continues to fall the dollar should push even higher.  

Interestingly, if we look at the ratio of the current change in the dollar in the next chart and compare it to the period 1997-2002 you can see that they are remarkably similar. That suggests that the ultimate target for the index is 93.5 by 2018 i.e. 22% higher or just over 4% a year. This fits nicely with numerous forecasts that suggest that while shale oil production will ramp up rapidly over the next few years it will start to plateau as we approach the end of the decade. 

At this point some of you will be saying; wait won’t the Fed act to prevent a dollar rally? The thing is that there’s a very big difference between a dollar shortfall triggered by a collapse of the US banking system and one caused by structural shift in US imports of foreign energy. Bottom line, as long as the move is orderly and not too disinflationary here in the US, a gradual dollar move should be ignored by the Fed. Conceptually, the Fed could cushion the dollar shortfall overseas by allowing central banks to run up swap lines but outside systemic risks there’s likely to a domestic politically imposed cap on their generosity. Alternatively, the private sector could suddenly start lending or spending dollars overseas but on balance I just don’t see that offsetting the gravitational pull of falling energy imports or the slow end of QE.  

History is littered with examples of crises such Latin American in 1982 or Asian in 1998 that are triggered by policy or economic shifts in the US. This time will be no different. When push comes to shove US policy makers will once again pay scant attention to their obligations as the global reserve currency. For anyone invested in countries with sizeable current account deficits (South Africa, Turkey etc.), companies with large dollar denominated debts (Chinese SMEs) or economies that are disproportionate dependent on commodities aka Australia (one of my favourite shorts) they should be very worried. The recent volatility in these markets is just a taste of things to come as the dollar rallies. Indeed, one EM Fund manager told me last week that ‘the last inflows we got into the fund were in March and asset allocators now have no interest in EM. They are concentrating on Europe and the US, where things now look far more attractive. Unfortunately, while funds sold enough assets in the recent meltdown to cover 5-6 weeks of redemptions they are generally out of cash now and further dollar strength could turn things very ugly.’  

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The material contained herein is the sole opinion of Macro Intelligence 2 Partners LLC. This research has been prepared by Macro Intelligence 2 Partners LLC using information sources believed to be reliable. Such information has not been independently verified and no guarantee, representation or warranty, express or implied, is made as to its accuracy, completeness or correctness. It is intended for the sole use by professional investors to whom it has been made available by Macro Intelligence 2 Partners LLC. The delivery of this report to any person shall not be deemed a recommendation by Macro Intelligence 2 Partners LLC to effect any transaction in any securities discussed herein.