Dollar devaluation does not mean dollar catastrophe

Many prominent economists and business leaders warn of dislocations in the global bond market. In the last few weeks, we have seen the conversation drift away from tariffs and towards the more pressing issue of debt market dislocations. 

We believe that businesses and investors need to accept that the world going forward will be more volatile and unpredictable. However, a clear pattern begins to emerge. The Fed can mitigate some of the economic shocks and stabilise bond markets. To do this, however, it needs to print money, which means further pressuring the dollar down. So far, the dollar index (against a basket of currencies) has lost 8% from its peak. This would not necessarily be incompatible with the White House’s aspirations of reducing the debt in real terms, reducing the trade deficit and rekindling manufacturing. Nor would it necessarily threaten the global currency reserve status of the Greenback. 

In the past weeks, we have heard many warnings coming from eminent personalities of the business, economic and financial world. Jamie Dimon, CEO of JP Morgan warned of “Cracks in the bond market that are going to happen”. Maurice Obstfeld, former Chief Economist of the IMF, as well as Nobel Laureates Paul Krugman and Joseph Stiglitz, suggested that the US is both in for higher inflation and much slower economic growth. Kenneth Rogoff, Chair of International Economics at Harvard (and Chess Grandmaster at 25), warned that the White House has “accelerated the dollar's decline and brings us closer to the day when US debt triggers a crisis”.

Is it really that bad?

Well yes and no. It all sounds very horrible until we begin acknowledging higher uncertainty and volatility as par of the course.  We, as in my generation, have spent many years in the “Great Moderation”, a time when inflation exported from China lowered macroeconomic volatility, making the life of central bankers a lot easier. After globalisation peaked, around 2008-09, and following the disruption of the Global Financial Crisis, central banks made sure market volatility was repressed along with economic volatility. Between 2009 and 2022, the Federal Reserve suppressed both the short and the long end of the yield curve, printing money at any sign of distress, essentially treating investors as a group that needed to re-learn to take risks in baby steps. 

While that crutch was violently removed after 2022, when inflation forced a series of rate hikes and the demolition (for lack of a better word) of a 30-year bull market in bonds, we still, to this day, remain a generation of investors and business people whom market and economic volatility are the exception, not the norm.

Our Chief Investment Officer, Ben Seager-Scott, and I, have often noted that the “New Normal” is actually a return of the “old” normal, when China was no longer exporting so much deflation to the world (it still does up to a point) and when central banks would not print billions responding to every impulse from the equity and the bond markets. A time when investors and businesses built plans expecting and preparing for the unexpected and treating volatility as an opportunity as much as a threat. “Resilience”, which might have been too expensive in a low-tariff, just-in-time-inventory world, is key in this environment. It would be naïve to expect a return to a low volatility environment when global debt grows at the present alarming pace, pressuring economies across the globe.

We have, in our previous publications, factored in lower US and global growth, and higher US inflation. The likelihood of both increases significantly in the third quarter of the year when pre-tariff inventories begin to run out. As such, market volatility is also part of the course.

At the time of writing, the assumption that by then the trade war will be over (despite last week’s initial ruling against tariffs) seems excessively optimistic, as the US government seems intent on raising money from tariffs and using access to the US consumer (as well as security) as bargaining chips for future trade deals. This trade war should not be seen as one man’s folly but rather as fuelled by large geopolitical and geo-economic themes, like the inevitable clash between two superpowers (US and China) and the debt build-up.

To be sure, elevated inflation makes the job of the central bank difficult, as it may have to choose between its growth and inflation mandates. But over and above those mandates, they have another: financial stability. If Mr Dimon’s warnings about rising debt affecting bond markets are right, then the Fed will likely have to re-start bond purchases to make sure the Treasury market remains stable and keep the government funded at the same time. And while it may seem like the central bank independence is sacrificed to the gods of politics, we should remember that central banks are not independent enough to ignore the political predicaments of their own countries and could print money to fight fires, like the ECB in 2012, the Bank of Japan for over 40 years or the Bank of England after the disastrous mini-budget of 2022, to name a few.

So, while the warnings are all too real, and definitely voiced time and again in this newsletter, investors and businesses would do well to remember that, in this monetary world, central banks can absorb a lot of the shocks.

What is the downside? 

Currency devaluation. For a central bank to stabilise markets, it needs to increase the money supply (to issue money and pay for the government debt it purchases). This could bring the currency under pressure. And much talk is being made about the Dollar lately. The US government faces a debt-to-GDP of 134% and a deficit of 9% by the end of 2034, even without the provisions of the new tax bill accounted for. As such, investors are more reticent to buy US debt, which makes it more palatable for the central bank to intervene.

Is it the end of the Dollar as a global reserve?

Hardly. From the 750 currencies used in 1700, around a fifth remains, and all have devaluated. The US Dollar alone has experienced 3 +30% devaluation episodes since the 1970s.

Yet, none of these have come near to stripping the Dollar of its reserve currency status.

The currency reserve status is a behavioural issue. Which currency will someone in Turkey or Argentina or another country with high inflation choose to convert their salary into at the first of the month? Which currency will they choose when their own face a crisis or a devaluation?

The Dollar is down 8.5% versus its recent highs and could lose as much as another 34% to reach post 1970s lows without - based on historical evidence- risking its reserve status.

It will take decades for the dollar’s status to change. In the meanwhile, it is likely that currency devaluation is the major course open for the government which faces a rapid debt build-up and wants to reduce its trade deficit. At the end of the day, currencies devalue mostly against their own debt. The question is, will other countries follow, triggering not a trade war, but its ugly cousin, a currency war? But this is a conversation for another day.

George Lagarias – Chief Economist

Market update

Over the holiday-shortened trading week, global stock markets posted a rebound of +1.7%, led by US equities with gains of +2.5% and followed by EU and UK equities with increases of +0.9% and +0.7% respectively and a decrease of –1.0% in EM equities space. The rally was initially driven by the US administration’s decision to postpone the imposition of a 50% tariff on European imports until July 2025, which temporarily eased investor concerns over escalating trade tensions. Further gains were seen later in the week after a federal court ruled against the administration’s authority to impose many of the tariffs, therefore putting their legality under question, though gains were tempered after that decision was quickly paused pending appeal. This legal uncertainty, combined with mixed messages on US-China trade negotiations and unpredictable political commentary were some of the causes for volatility. Nonetheless, improved consumer confidence – reflected in a sharp rise in The Conference Board’s index – helped support market sentiment, particularly in consumer-facing sectors.

Japanese equity markets posted strong gains of +1.4% over the week. This rally was largely fuelled by renewed optimism surrounding trade negotiations between the US and Japan, which lifted investor sentiment.

In the bond markets, high yield bonds outperformed US Treasuries, predominantly due to the equity rally, positive sentiment from delayed tariffs, and a rebound in consumer confidence. The US 10-year bond yield fell by –11 basis points, whereas the UK 10-year bond yields only fell by –4 bps (bond prices and yields move in opposite directions).

Oil prices fell by –1.7%, for the second consecutive week, primarily due to expectations of OPEC+ announcing another production increase in July.[SB1]  This anticipated rise in supply came at a time when global inventories surplus has already widened to 2.2 million barrels per day. Finally, gold prices also edged lower by –1.5%, influenced by the tariff reprieve, boosting risk appetite and increased expectations for interest rates to stay high,[TY2] which tends to reduce the appeal of non-yielding assets such as gold.

Macro news

There was a lot of tariff activity last week, starting with European Union negotiations and ending with domestic legal challenges in the US. The threatened deadline that would see the US impose 50% tariffs on imports from the European Union was extended from 1 June to 9 July to allow more time for a deal to be negotiated after US President Donald Trump and European Commission President Ursula von der Leyen spoke on the phone. Later in the week, the US Court of International Trade deemed some of the broad tariffs illegal under the International Emergency Economic Powers Act – this would invalidate tariffs including the 10% global tariff and the additional reciprocal tariffs on specific countries. However, the ruling does not affect tariffs on sectors such as steel & aluminium or autos which are implemented under section 232 and 301 orders – we will likely see the use of these therefore increase, and we have highlighted previously how the approach to these strategic areas has been designed to be more legislatively robust. As it stands, the ruling’s impact is suspended pending the outcome of various government appeals.

US durable goods orders fell by 6.3% in April as the effects of the blanket 10% tariffs on imports impeded demand. The move was a reversal of the previous month, in which durable goods orders rose by 7.6% due to the front-loading of orders in anticipation of tariffs. Orders for non-defence aircraft and parts (including aircraft for commercial airliners) were the most dramatically affected, falling by 51.5% from the previous month. The April figure was slightly better than expected as consensus estimates had predicted a sharper drop of -7.8%.

Long-term government bond yields have been rising globally as investors reassess the implications of large government debt loads, higher inflation uncertainty and more restrictive central bank policies. Weaker-than-expected long-term bond auctions in the US and Japan last week spurred a sell-off in longer duration assets, including 30-year gilts and technology stocks. The moves saw a partial reversal early this week after the Japanese Finance Ministry signalled the possibility of a reduction to the issuance of long-term bonds.