US Fiscal Disorder Meets Dollar Strength: Decoding the Conundrum

US debt seems out of control as the Congressional Budget Office (CBO) recently announced that inspite of robust growth and low unemployment, FY24 fiscal deficit will be $1.9 trillion, 12% above last?year's $1.7 and 27% above the previous estimate for FY24.? The US fiscal stability appear to be deteriorating rapidly, increasingly resembling that of a Latin American country circa 1990.?

The debt-to-GDP ratio is approaching World War II levels, with no sign of political will to address fiscal consolidation. The US also continues to import far more goods and services than it exports, despite a massive energy trade surplus.

Classical macroeconomics would suggest such conditions should negatively impact the currency's value, yet the opposite has occurred. The DXY, the index tracking the dollar against major currencies, has been in an uptrend for the last three years and is already up 4.4% in 2024.

What explains this paradox? Several considerations are worth examining.

The value of a currency must be measured relative to a benchmark, typically other currencies. In this context, the dollar's strength reflects the weakness of other currencies in the index, primarily the Euro and the Japanese Yen, which together represent 70% of the total basket. While dollar-denominated debt enjoys more favorable rates, the interest rate differential alone is not the driver of the dollar's strength. For instance, Turkey's 10-year bond yield is 27%, yet it fails to attract significant demand from global investors. Simply put, markets view the Eurozone and Japan's macroeconomic conditions even less favorably than those of the US. All other factors being equal, the US economy is considerably stronger, with GDP growth and productivity consistently outperforming both the Eurozone and Japan's.

A currency can also be measured against various other benchmarks, typically valuable assets with liquid, global markets. These include oil and other commodities, precious metals, and more recently, Bitcoin. When the dollar's value is assessed against these benchmarks, the results differ significantly. Since the beginning of the year, the greenback has lost 12% against gold, 13% against oil, and a staggering 43% against Bitcoin.

Over a five-year timeframe, the dollar's devaluation is even more pronounced, having lost 66%, 30%, and 494% against gold, oil, and Bitcoin, respectively. Nevertheless, over the past five years, the dollar has performed far better than other major currencies, with the DXY gaining 10%.

Investors should draw key fundamental lessons from these observations.

Given the current entrenched fiat money system, hedging currency risk or seeking refuge from devaluation through exposure to any other currency than the dollar is largely ineffective. Despite growing fiscal and trade deficits, the USD will likely remain the "cleanest shirt in the dirty laundry basket" for the foreseeable future. Moreover, the dollar may further appreciate against other currencies as competition with China intensifies. The Ukraine sanctions have underscored that decoupling from the dollar system is crucial for China's survival , hence its promotion of a dedollarized trade with like-minded nations. The best U.S. strategy to counter this narrative is ensuring the dollar remains a reasonably stable and attractive option for trade and reserve assets. Considering this and the dire situation of other major economies, the DXY could potentially reach new highs . Crucially, a stronger dollar coupled with restrictive trade policies would also serve as a potent weapon against China, which still requires substantial amounts of U.S. currency despite its dedollarization efforts.

Global investors should be cautious with non-USD denominated assets, as these may ultimately suffer from currency decline regardless of the asset's underlying economic performance. A sobering example is investment in Australian property,?often considered one of the strongest property?markets globally; while the asset class appreciated 30% over the past decade in local currency terms, the latter also depreciated 30% against the dollar, leaving international investors with a significant loss when ownership costs and inflation are factored in. Similarly, fixed income investments in most developed markets have seen their already modest yields effectively negated by currency devaluations against the greenback.

The most effective strategy for investors to protect against inevitable dollar devaluation is exposure to real assets. However, is best to prioritize assets whose primary function is store of value, as others, such as oil or agricultural commodities, are susceptible to various factors including economic growth and technological disruption. As frequently discussed in these posts, gold and Bitcoin remain optimal choices, provided they are self-custodied and held in physical form, rather than as "paper" assets. Lastly, historical data indicates that selected equity sectors, rather than generic indices, may also serve as value stores assuming the underlying companies successfully navigate economic, financial, and geopolitical cycles.

In conclusion, the US dollar is unlikely to weaken significantly, and evidence suggests further strength driven by economic and geopolitical factors. Therefore, direct or indirect exposure to other currencies is inadvisable for the foreseeable future. However, the greenback's relative resilience should not engender the impression that the dollar is a reliable reserve asset. On the contrary, US debt levels and various macro factors necessitate currency devaluation for systemic "reset." Those keen to preserve their wealth's purchasing power should prioritize exposure to the aforementioned "antifragile" stores of value before considering carefully selected equity sectors.

Disclosure: Not investment advice. Do your own research. Hold all assets mentioned. X @pietroventani for more timely comments and updates