The recent rally in the US dollar after fears about a slowdown in China and Eurozone government debt has focused attention on what lies ahead for the world’s major reserve currency and the implications for funds’ hedging strategies.
On one side of this debate is Mountain Pacific Group chairman, Ron Liesching, who says that the global value of the US dollar is slipping every year and that funds are looking to explicitly hedge what he calls their “US dollar risk”.
However, State Street Global Advisors managing director and head of currency management, Collin Crownover, has a more positive take on the US dollar, saying it could be on the cusp of an upswing. Crownover sees a number of potential drivers for a strengthening US dollar.
These include the end of the US Federal Reserve’s second round of quantitative easing in June that removed some of the supply of US dollars.
Recent good economic data coming out of the US also stands in contrast to other major economies, particularly the UK, Japan and many Eurozone countries.
“We can all tell stories about demand for commodities and emerging market growth and why those currencies could appreciate more versus the US dollar,” Crownover says.
“But if I am looking at the euro, the yen and the pound it is getting increasingly difficult for me to tell a story where the US dollar continues to weaken against those major currencies.”
Liesching, however, says the US dollar no longer represents a safe store of value and is in a similar position to the pound sterling when it lost its primacy as the global currency after World War II.
He estimates that the US dollar may be falling in global value by as much as 2 per cent each year.
The causes of this decline, Liesching says, lie in the “privileged” position of the US whereby they have been freed from having to limit their domestic spending to their domestic savings due to the US dollar’s position as the world’s leading reserve and trade currency.
Liesching argues it that has allowed the US to run up unsustainable internal and external deficits, which eventually reach a tipping point where foreign investors doubt the value of the currency.
“This abuse of reserve currency role is now happening for the US dollar, euro, yen and sterling,” Liesching says.
“If you abuse this privileged reserve currency role, your currency will enter a volatile, but secular, decline in role and value.”
While the US dollar’s reign as the world’s major reserve currency is, at the moment, unchallenged, this month the World Bank predicted that it would lose its solitary dominance in the global economy by 2025.
The World Bank said “emerging economies will grow at 4.7 per cent between now and 2025, a much faster pace than the 2.3 per cent expected growth for advanced economies over the same timeframe”.
The implications are wide-ranging, including increased investment flows to emerging markets, and a different international monetary system evolving, with the Chinese renminbi and the euro likely to also compete with the US dollar as fully fledged international currencies.
Some experts, such as high-profile currency commentator and head of HSBC’s head of foreign currency strategy, David Bloom, argue that the US dollar’s era of primacy has already ended.
Bloom recently described the US dollar as behaving increasingly like a residual currency, turning on its head accepted market rationales for how the greenback might typically move as a result of global economic changes.
He says emerging market currencies and risk assets are taking on a primary role. The effect being that good news out of the US could actually weaken the US dollar as confident investors seek risk in emerging markets.
Inversely, news of a worsening debt scenario in Europe or the US could lead to investors shunning risk and subsequently the US dollar strengthens.
But Liesching and other currency experts believe the US dollar is no-longer the safe store of value it once was.
They commonly point to the two rounds of quantitative easing by US Federal Reserve as exacerbating the further debasement of the long-term value of the US dollar.
Playing into this theme is the growing strength of emerging market currencies, driven by strong economic fundamentals and, Liesching argues, a desire by investors to also diversify their currency risk.
Mountain Pacific have been working with a number of new sovereign wealth funds and public funds to design strategies to diversify their currency risk, including moving away from a concentration of assets held in US dollars.
While overseas funds have been seeing the risk in US dollar, some US pension funds are also moving to manage this currency issue, Liesching says.
“Most US pension funds still believe that if they have US dollar nominal liabilities, then they have no currency risk if they keep their assets in US Dollars. In an accounting sense that is clearly correct,” he says.
“But you have to be careful in examining risks that accounting hides: if pension fund accounting allows you to amortise portfolio losses, it does not mean the losses have not occurred.”
Liesching claims that in the past decade there has been what he describes as “a very major shift” within the investment teams in US pension funds.
This has resulted in some funds in the US bolstering the global equities allocation in their portfolio and a strong move away from hedging foreign currency exposure, Liesching says.
“They want the diversification and returns that foreign currencies provide,” he says.
“The latest stage is for US funds examining explicitly how to hedge their US dollar risk. It is an idea that would have been unthinkable a decade ago. It is an idea whose time has come.”
Crownover, in his role as State Street’s head of currency management, says that wherever he goes in the US, he is constantly asked about whether the slide in the US dollar will continue.
He said the current slide in the US dollar is more cyclical and is less about fundamental structural shifts.
Rather than expectations of the US dollar continuing to slide, Crownover says he sees investors thinking about if the conditions are right for a turn-around in the US dollar, particularly against other major currencies.
Given that the economic date coming out of the US is stronger relative to the UK, Japan, and most countries in the Eurozone other than Germany, Crownover argues that investors are, in fact, now looking at their foreign currency risk.
“We are seeing people starting to look at their unhedged foreign currency exposure and thinking: ‘maybe I should be hedging some of that back into the US dollar’ as opposed to saying: ‘let’s get even more outside of the US’,” Crownover says.
While acknowledging that the US government is facing serious debt problems, Crownover says, that compared to other major developed economies, their debt levels are not as problematic as some would suggest.
But he thinks debt problems could loom larger if the US Government does not act quicker to rein in its current high budget deficits.
While some currency experts have also pointed to the Federal Reserve’s two rounds of quantitative easing as amplifying the slide in the currency, Crownover thinks they won’t have a negative long-term impact on the value of the US dollar.
“The only reason you would turn away from the US dollar as a reserve currency is if you somehow thought there would be elevated inflation and an active policy of currency debasement,” he says.
“Despite all the talk of about the Federal Reserve printing dollars, it hasn’t been massive relative to the balance sheet of the country.”