The Bear Case for the US Dollar

In our view, we stand on the cusp of a major transformation in the FX markets:

The likelihood of significant depreciation of the US dollar relative to other currencies over the next several years.

Allow us to elaborate.

The Fed's current interest rate policy is entirely misaligned with the magnitude of the debt problem, putting the US economy in a precarious situation. This issue is notably more severe compared to other developed countries.

As shown in the prior chart: According to OECD, by next year the US will face by far the highest cost for servicing its debt among all democratic developed market economies it tracks by next year.

This predicament has swiftly shifted from a long-term issue to an immediate challenge, and we believe it may force several reductions in the Fed funds rate that call into question the Fed’s ability to achieve its dual mandate of maximum employment and price stability.

Such a drastic reversal in policy stance by the Fed is likely to exert substantial downward pressure on the dollar relative to hard assets, but also versus other fiat currencies that do not face the same urgency to reduce debt costs.

Additionally:?

Irrespective of the political party in power, the following chart is probably the most important issue in today's economy, which we anticipate will likely have major implications for the US dollar.

Net interest payment as a percentage of GDP is projected to reach its highest level in over two centuries. Note that the 4.1% figure for 2034 is based on CBO estimates which historically have been too optimistic relative to ultimate reality.

The core of this perspective is that the potential near-term benefits of cutting interest rates to ease the debt burden are tangible and achievable but also likely at odds with the Fed’s long-term goal of low inflation and full employment.

While other economies may have worse debt imbalances, none experience the same level of pressure from debt maintenance costs as the US.

Let's use Japan as an example.

The Japanese economy is one of the most indebted developed nations globally that has managed to maintain an exceptionally low cost of debt through interest rate suppression and yield curve control measures.

This approach, however, led to a significant devaluation of the yen.

Additionally, observe where debt service levels are today compared to the 1940s, when the debt issue was equally severe. The urgent need for financial repression in the US economy has never been more apparent.

From a macro perspective, America's exceptional economic growth has been primarily driven by its significantly large fiscal deficits compared to other nations.

Since 2009, the US has run the steepest government deficit relative to GDP among any other country.

We believe this spending differential has spurred growth and attracted capital to US financial markets, explaining why the rest of the world has drastically underperformed for more than a decade.

This “fiscal exceptionalism” has been made possible largely due to the US dollar's role as a reserve currency, which allows the US to pursue a more expansive fiscal agenda than other countries.

Given the surging cost of debt, it is reasonable to question whether the US economy can continue to sustain this level of fiscal dominance, particularly in comparison to other nations.

Historically, three potential solutions have emerged for addressing such a challenge:

??? Austerity measures

?? Political tools to suppress debt service costs

?? Or, more radically, debt restructuring

The 1940s served as a relevant example, where the US used these strategies, achieving a primary fiscal surplus and employing yield curve controls to lower interest rates. Allowing inflation to surpass historical norms also helped reduce the debt imbalance significantly.

We believe a similar policy mix is necessary today, with interest rate suppression likely being the most effective initial measure given the current AI revolution, electrification, onshoring, manufacturing modernization, and increasing deglobalization.

As Stanley Druckenmiller once observed, one of the most effective ways to strengthen a currency is by adopting a tight monetary policy alongside an aggressive fiscal agenda.

This playbook has kept the dollar strong, but it is unsustainable due to the current debt cost imbalances.

Currency markets behave on a relative basis, and the pressing need for the US to adjust its interest rate policy indicates that the dollar is likely to face adverse effects from these potential changes in monetary and fiscal stance.

To clarify:

The central issue is not the debt imbalance per se, as history has seen even more severe public debt distortions. The real problem lies in the disconnect between the current interest rate policy and the size of the federal debt.

To manage the existing liability effectively, substantial reductions in debt service payments relative to GDP are necessary, which is in stark contrast to the approaches taken by other economies at present.

?See the chart again:

It is crucial to pay attention to assets that exhibit resilience despite major macro headwinds that should typically negatively impact their prices.

This is exactly what we are observing with most currencies relative to the US dollar recently.

Multiple fiat currencies have begun to show remarkable strength, potentially marking a historical bottom, despite one of the most aggressive interest rate differentials between the US and the rest of the world.

The positive carry for holding US dollars should be driving a major inflow into the currency, particularly compared to gold and other hard assets. Instead, we have seen metals surge during one of the most aggressive hiking cycles since the 1970s.

These changes in market structure are notable and likely mark the beginning of a trend. We tend to favor currencies of economies with significant exposure to natural resources.

Additionally, declining trends in the dollar tend to benefit emerging markets.

To summarize our thesis:

We anticipate that, following the chain reaction from entrenched inflation to rising interest rates and falling sovereign debt prices, the US dollar will likely be the next to decline, driving precious metals significantly higher.

See below our latest research letter:

https://www.crescat.net/the-bear-case-for-the-dollar/

Hope you enjoyed this article. Have a great weekend.

-- Tavi Costa