US Dollar Spikes Can Happen Suddenly. What Are the Consequences For Investors?

The US Dollar shortage has eased considerably since the height of the crisis in March 2020. We can see that the Federal Reserve has been closing Swap Lines to allied countries, as they no longer require Dollar funding. Why? Because Dollars are abundant. The Federal Reserve made sure of that by printing more debt, and providing Swap line facilities.

Risk

Sudden spikes in the dollar can cause tremendous turmoil because Global trade has essentially peaked in the past decade, this means there will be less dollars traded. A Dollar shortage effectively means that it will be more expensive for Countries Ex-US to buy oil, copper, and other raw materials that are exclusively traded in the greenback. This poses a problem for nations or foreign corporations who have debt in dollars, and no longer have access to US Dollars. Currently, there is 12 Trillion USD in debt taken on by foreign nations and companies (BIS).

What do they do if they lack dollars to service their debts? Well, they also own around 40 Trillion USD in US Assets, with 7 Trillion USD in US Treasury debt (notes, bills, bonds). They can sell these assets, especially given the low return outlook for US Equities, and Bonds. Foreign entities will be forced to sell US Equities to service USD debts. As a result, this will not only flush out the excessive dollar demand driven by debt, it will also potentially remove excesses in US stock market and bond valuation.

This could signify a very real risk in US Investment Assets. Especially since, the demand for US assets has meant that the US was able to run large Current Account (Exports-Imports) deficits. The demise of the Capital Account (foreigners demanding dollars to buy US assets), will put a very difficult strain on the US economy. The US will no longer be able to enjoy the luxury of Current Account deficits, putting its reserve currency status into jeopardy. This could lead to unacceptable levels of inflation, as the Dollar devalues. The Fed may look to raise interest rates to control inflation, by which it would most likely be too late.

Opportunity

This can explain why so many Asset Managers are now looking for returns outside of the US. The risk to reward profile has diminished after the rally from the March lows. Prime Brokers and Investment Research Firms have been forecasting US Equity returns below 5% for the next decade. Equities have been run up because there has been no alternative for Investors given that Risk Free Rates are near zero or negative in some cases. However, equities have a ceiling in which they can run. As long as they are attractive in terms of cash flow yield against bonds.

Gold and certain Emerging Market plays will be the beneficiary of a weaker dollar in the long term. As confidence in the USD, and US Assets start to frail, the World will look to Gold as a suitable alternative, as it has served Global trade in the Pre- Bretton Woods era, and is a proven store of value. Emerging Market Equities and Bonds are relatively more volatile, yet look considerably more attractive than Developed Market equities. They also have high growth potential due to higher population growth rates, and higher urbanization rates. Countries like China, have shown they are willing to engage in large scale infrastructure builds to cater to growing populations and serve a more connected world. Yet, one must be selective in sector, industry, and security selection. As we have seen in the COVID-19 era, lock downs resulted in very different destinies for Tech companies, and the broader market.

Advice for Investors

Diversification and risk management should be at the heart of any investment process. This entails maintaining a long term investment objective, and weighing the opportunities against the risks. The key is to diversify across risk categories, for example; even if you believe the dollar will strengthen further over time, it is still wise to hold a certain percentage of your portfolio in Gold. This way an investor can hedge their views, granted this may affect the return profile of the investment, as it is always about achieving a balance between risk and reward that is acceptable to the investor.