The Complicated Backdrop of the
Weakening of the U.S. Dollar

On September 27, 2022, the dollar hit a 20 year high, as measured by the U.S. Dollar index, which measures the currency against a basket of six other major currencies. Since then, the dollar is down approximately 14% as of April 13, 2023, the Fed has continued to hike rates, credit conditions have tightened meaningfully following the biggest bank failures since 2008 and geopolitical tensions, specifically with China, have continued to rise. Is this the beginning of a longer term weakening of the U.S. dollar or is this a temporary drawdown from an all-time high before the dollar finds a state of relative stability?

The dollar is still the dominant global trade currency and is not likely to give up that status in the near term. The Dollar still makes up nearly 60% of foreign exchange reserves, with the next closest currency being the Euro at just over 20% of foreign exchange reserves.

Currently the Dollar trades at potentially overvalued levels against currencies like the Japanese Yen or the British Pound, which is at its weakest level against the dollar since 1985. As global growth catches up with the U.S., it is reasonable to expect the relationship between these currencies to normalize towards long-term averages from the currently stretched valuations. If this mean reversion is realized, there would be a weakening of the U.S. dollar.

Post Covid there certainly has been momentum around the idea of “de-globalization” and moving away from the U.S. dollar as the primary currency of exchange in global markets. This idea of currency diversification could lead to a further weakening of the U.S. dollar, but it would need to accelerate significantly to lead to a broader de-dollarization.

Considering this data, when we think about a potential weakening of the U.S. dollar, we aren’t referring to a full-scale regime change within global markets away from the dollar, rather just a persistent bear market for the dollar over the short and medium term. And while that might not have a meaningful impact on the dollar’s role in countries’ currency reserves or impact its role in global trade, the potential weakening of the U.S. dollar can have significant impacts on investment returns.

The dollar strength leading up to this point has been understandable. The Fed’s hawkish stance has made U.S. yields among the most compelling for global investors and otherwise strong economic data suggest that the Fed will continue to hike rates. Interest rate differentials are a key driving force in currency markets and until recently the U.S. has offered some of the best real yields. As other central banks catch up with the Fed’s hiking schedule and global inflation data softens more than in the U.S., we could see a reversal in this trend and a weakening of the U.S. Dollar.

Rising Rates and an Impending
Credit Dislocation

Persistent inflation in the U.S. could be another reason we may see a weakening of the U.S. Dollar. Inflation initially impacted all developed markets and countries within the Eurozone were experiencing some of the highest inflation rates. Recent data suggests that disinflationary efforts from the European Central Bank (ECB) are taking hold more than those from the Federal Reserve in the U.S. Inflation is a very important factor when considering currency strength or weakness, because while higher yields could increase flow into a particular currency, inflation causes those yields to be less compelling on an adjusted or real basis. It follows that if U.S. inflation persists more than other major global markets as recent data suggests, we could see a further weakening of the U.S. dollar.

Volatility within equity and credit markets, like the volatility we have seen following recent bank failures, could be supportive to the dollar and result in further strengthening, rather than weakening of the U.S. dollar. This may seem initially counterintuitive, but history suggests that during times of market stress investors tend to flock to the dollar and dollar-denominated securities. This is because the dollar and dollar-denominated securities, like treasuries, are considered safe havens. This is important because global market stress would likely strengthen the U.S. dollar but market volatility that is contained within U.S. markets would likely contribute to the weakening of the U.S. dollar.

Rising Inflation – Are Inflation
Expectations ‘Bubbling Up’?

It is impossible to discuss the outlook for the U.S. dollar without considering China’s role. Recent currency conversations have been framed as the strengthening of the Chinese Yuan vs the weakening of the U.S. Dollar. After all, if the U.S. Dollar gives up market share, then another currency has to claim it and the Yuan seems like a natural and willing candidate. Elevating the Yuan in global markets is a priority for China, they have taken measures within their domestic banking system to support the yuan, they have continued to push (although unsuccessfully) towards using the Yuan to price oil, and have taken other measures to make the yuan more regionally relevant through strategic partnerships with other Asian countries like India and Russia.

China’s geopolitical and diplomatic efforts to build ties with countries like Saudi Arabia, Russia and other members of the Gulf Cooperation Council (GCC) and OPEC is directly related to their goal of adoption of the petro-yuan, that is using the yuan to price oil. Currently the dollar is used to price oil. This practice results in a built-in demand base for the U.S. dollar and therefore price support, this is due to the fact that most oil transactions are conducted in the U.S. dollar. If the petro-yuan was widely adopted, then it would be a blow to the U.S. dollar and win for the Yuan. And while some transactions are settled in currencies like the yuan and the Russian Ruble so far there is little momentum behind the petro-yuan.

Characterizing the current relationship between the U.S. and China can be challenging. An optimist might say it is currently tense but not a concern in the long term, a pessimist might suggest it is a tipping point and is beyond repair, as with most things in markets it likely rests somewhere between the two. The two countries seem to be engaging in a race towards semiconductor self-sufficiency that has shades of the space race between the U.S. and the then USSR during the cold war. Central in this race is Taiwan Semiconductor Manufacturing Company (TSMC). TSMC is the world’s largest dedicated semiconductor foundry and is a major supplier for many U.S. tech companies. China recently launched a series of military exercises off the coast of Taiwan seemingly in response to a series of meetings between the Taiwanese President and U.S. government officials. If tensions escalate, or if real military action is taken, it could meaningfully disrupt supply chains and drive a new wave of inflationary forces into the U.S.

It is challenging to say how exactly U.S. and China relations will play out and even harder to forecast how that resolution (or lack thereof) will impact the dollar, but it would be incomplete to consider the potential weakening of the U.S. dollar and not consider what China’s role might be.

Forecasting is always challenging and forecasting currency returns might be the toughest to predict in markets, due to how interconnected FX markets are. Directionally the data suggests that we will see a weakening of the U.S. dollar, but the path there and the magnitude of the weakening are very much unknown. What we do expect is that we will continue to see volatility within global markets, FX included. It will be important for allocators to consider sourcing managers with a track record of success trading macro themes. At Crystal Capital Partners, we work hard to find managers with long-term track records who have historically displayed a skill set in navigating markets with dynamic currency regimes.

China, Russia, and the West:
A Game of Chess

Sources:

1. China yuan's long-term strengthening trend will not change - state media | Reuters
2. Dollar weakens as inflation data lifts euro | Reuters
3. After hitting a 20-year high, the U.S. Dollar Index is weakening fast (axios.com)
4. Dollar gains in safe-haven buying as Credit Suisse sparks wider banking fears (cnbc.com)
5. Will the U.S. Dollar Be Dethroned? | Charles Schwab
6. Global inflation tracker: see how your country compares on rising prices | Financial Times (ft.com)
7. Pricing Petroleum in China's Yuan Sounds Inevitable. Not for Saudi Arabia. - Bloomberg
8. China’s Central Bank Moves Further to Bolster the Yuan - WSJ
9. Why China's central bank is shoring up the yuan (cnbc.com)
10. China’s Yuan (CNY) Replaces Dollar (USD) as Most Traded Currency in Russia - Bloomberg
11. China seethes as US chip controls threaten tech ambitions | AP News
12. China’s Military Greets Return of Taiwan’s President With Live-Fire Drills - WSJ
13. Currency Composition of Official Foreign Exchange Reserve - At a Glance - IMF Data
14. Russia Turns to China’s Yuan in Effort to Ditch the Dollar - WSJ
15. Pricing Petroleum in China's Yuan Sounds Inevitable. Not for Saudi Arabia. - Bloomberg