Since the global financial crisis, it has become fashionable to trade currencies from a shorter term perspective, and to focus on tail risk events rather than on the base case scenario. The return of regulatory, social and political risks has polarised markets on the possibility of binary outcomes. Although traditional business cycle relationships may no longer hold, we can still rely on a fundamental framework for currency analysis. We believe long term economic trends and country risk assessment provide a useful toolkit for analysing the outlook for the dollar in particular.

From single to multi-currency regime
Starting with the long view, we see a continued erosion of the pre-eminence of the dollar as a world reserve currency. Emerging markets (EM), which have contributed to the bulk of global FX reserves growth (to a total in excess of $9 trillion), have driven the shift out of the dollar. The share of the dollar in emerging markets central bank reserves has dropped from 75% of the total in 1995 to just 58% in 2010, according to International Monetary Fund COFER data. We see little reason for this trend to change much. The rise in emerging markets FX reserves has been broad based across exchange rate regimes (both fixed and flexible) and is explained by a variety of factors: an improvement in external balances reflecting better macro policies and terms-of-trade gains and more recently, a resistance to currency appreciation. In addition, there remains little appetite for an abrupt reduction in global imbalances through massive currency appreciation in emerging markets.

The bias of emerging markets for diversification seems to have been reinforced by the financial crisis. A number of Asian central banks suddenly found out in 2008 that part of their FX reserves held in US quasi-fixed income instruments were no longer liquid and could not be used to defend their currencies against external shocks. The rapid deterioration of US public finances and the ballooning of the Fed balance sheet in the wake of the credit crisis have likely started to undermine the status of the dollar as a reserve currency.

This is all the more likely as there is not just one alternative (the euro) to the dollar. Asian intra-regional trade has grown to about 40% of total trade. The tolerance of Asian central banks to currency appreciation is largely determined by the path of CNY. China anchors regional monetary cooperation and has de facto created a regional currency. Yet the daily turnover in dollar/CNY only represents 0.3% of the total, according to the Bank for International Settlements. China has to achieve currency convertibility on the capital account to bring financial flows more in line with its share in the world economy. This is part of the long term strategy of China, as evidenced by recent policy measures (RMB settlement of external trade, creation of CNH).

US mutual funds invest abroad
US mutual funds, the largest holders of dollars in the world (with funds of $38 trillion), tend also to need less and less dollars. They have increased their share of investment abroad from 12% to 27% between 2002 and 2010. The needs for further allocation to emerging markets can only grow. Emerging markets contribute to two-thirds of global growth. Their growth outperformance cannot be ignored, with their potential growth estimated at close to 6% against just 1.5% for advanced economies.

The growth attraction of the dollar has in contrast been dented. Even compared to other major economies, productivity growth in the US (or more broadly potential growth) is no longer a clear cut advantage for the dollar. There is much uncertainty about output gap measures. Yet beyond the precise estimates, we sympathise with the view put forth by the IMF that the financial crisis has added to demographics to dampen US potential growth . The slower growth in the working age population and a structural downward trend in labour market participation could reduce the labour input. In turn, the past outperformance of US potential growth versus the Eurozone could well be eliminated as much of it was due to a bigger contribution of the labour input. The gap between the US and the Eurozone as regards the capital input is also closing. The information technology related boom in investment spending in the US in the 1990s has been followed by an IT catch up in the Eurozone. Until the US economy comes up with a revolutionary innovation such as the internet, one of the questions nagging investors holding the dollar will remain: where is growth going to come from?

A deterioration in US credit quality
New sources of growth are all the more needed as the US sovereign credit quality has been severely downgraded. Gross general government debt will reach 100% of GDP in 2011 according to the IMF as wide budget deficits are posted (11% of GDP). The severity of the adjustment that would be needed to put public finances back on a sustainable path can only be compared to the one required in Greece, Ireland and Japan. The exorbitant advantage of being a reserve currency means much of the fiscal risk premium has so far not been priced into the dollar. Yet the average maturity of US debt is short (just over five years), leaving the US exposed to a loss of confidence. In addition, foreign investors hold about a third of US debt. Were it not for the Greek crisis, policy indecision in the face of much needed fiscal adjustment and market disappointment about the pace of activity would have triggered sharp and broad dollar weakness.

Currency markets may then be ill-advised to focus more on the Eurozone sovereign risks than on the US fiscal crisis. The balance sheet of the Eurozone as a whole is better than that of the US. Gross general government debt stands at 87% of GDP with a deficit expected at 4.4% of GDP in 2011. Germany could cover the sovereign financing needs of Spain in 2012 (8% of German GDP) without much impact on its own sovereign solvency: the total financing needs of Germany in that case would be no bigger than those of Canada (19% of GDP), and much lower than the US forecasts (28% of GDP) from the IMF. This observation is only for illustrative purposes, but there is no doubt Germany would (in the end) do whatever it takes to preserve the Eurozone project if it were at risk. In addition this computation serves to show that the current issues in the periphery could be solved without downgrading the long-term macro outlook for the Eurozone, which is anchored by Germany (solving the fiscal crisis will be a different story for the US in that regard). A combination of fiscal transfers from Germany (mostly) would go a long way in solving sovereign issues if combined with additional fiscal adjustment and in some cases debt restructuring (Greece, perhaps Ireland).

For the euro, as long as systemic risks are contained, the risks are not so much macro but risks associated with the bumpy transition towards a better political and institutional framework. The liquidity backstops created for countries in crisis (the European Financial Stability Facility, the European Stability Mechanism) and the upcoming permanent debt restructuring mechanism are already welcome improvements. Ultimately, the crisis could turn out to be a historical opportunity to take steps towards a fiscal union (eg. common bond issuance, budget policy), a long-term positive for the euro. In the near term, however, policymakers’ indecision means that the euro needs to price the risks of financial instability that would arise from a disorderly Greek debt restructuring, further contagion to other countries (insulating Spain from contagion is key) and the contamination to core Eurozone banking sector. If, as we believe, US fiscal challenges are more permanent than the concerns at the periphery of the Eurozone, then the case is for a long-term trend of dollar weakness to resume.

Macro differentiation to kick-in
We see scope for macro differentiation to drive currency markets over the coming quarters, provided global risk appetite stays constructive. We do not look for extreme financial stress such as in the wake of Lehman’s failure in 2008 or a “double dip” in global growth. In such a case, global risk aversion would rise sharply, prompting a sharp appreciation of the dollar. Barring this, currency markets should react to increased monetary policy divergences and macro performance between economies. Nevertheless, the interaction of sovereign risk issues with the business cycle has added a new feature to traditional market drivers. A sustainable but sluggish US growth recovery cannot give a lift to the broad dollar, as it is not associated with Fed near-term hikes in view of the US structural imbalances.

Easy broad financial conditions, including a weak currency, are needed to accommodate the process of debt de-leveraging. The solution to the credit crisis can only come through time and growth. Private sector debt was transferred in part to public sector balance sheets, contributing to the deterioration in US sovereign credit. Low interest rates, recovering asset prices and sustained growth are needed to reduce debt burdens to sustainable thresholds. This is what the Fed policy has contributed to deliver. Yet its success on the real economy has so far been limited. The pace of growth recovery is yet too slow for any tightening in monetary policy to be contemplated, if heavy fiscal consolidation is to be delivered. QE3 cannot be ruled out in that scenario. In all cases the Fed is under enormous pressure to continue to support the recovery.

Dollar lacks cyclical support
The current US growth recovery stands as an exception in recent history. In contrast to past recoveries the housing sector remains a drag on the economy. Given its implications for consumer spending, the persistent decline in housing prices, driven by high foreclosures and inventories, should not be overlooked. The consequent negative impact on households’ wealth could lead to renewed household debt de-leveraging if combined with a correction in equities. This highlights how fragile the consumer recovery is.

The other facet of the weak consumer story is the unusually slow decline in unemployment in this recovery. Buoyant corporate profits have yet to translate into a massive rise in hiring. The debate about whether the unemployment has mostly cyclical or structural roots has yet to be settled. But there is no shortage of structural factors affecting the labour market, including a mismatch of workers’ skills amid economic restructuring and credit constraints for smaller-sized enterprises. Whether cyclical or structural, elevated unemployment either calls for continued easy macro policies or bigger public investment in education and other growth-enhancing structural policies. In one case, record low interest rates would hit further the dollar on a broad basis. In the other case, given the fiscal constraints, the lack of policy room to invest in “soft” infrastructure would likely prove a long-term negative for US growth and the dollar.

The drag for the dollar from the policy mix is set to remain over the coming quarters. Monetary policy divergence between the US and the rest of the world can only increase, as the global economic recovery remains on track and faster tightening is delivered elsewhere (with the exception of the Bank of Japan). Historical analysis shows that it would take a significant gap between the Fed fund rate and the Bundesbank/European Central Bank rate to turn around the dollar. We find it very unlikely that the Fed will outpace the ECB in 2011 or 2012.

High commodity prices, especially oil prices, only add to the Fed policy divergence from the ECB for the dollar. A lot has been made of the euro/dollar and oil price correlation and we see this support remaining in place. The lack of spare capacity in the oil market and the continued supply-side risks arising from the Middle-East and North Africa crisis suggest risks on oil prices are on the upside. The recycling of emerging market reserves and the Fed dual mandate in contrast to the ECB focus on headline inflation have played out as expected.

A toxic combination
More fundamentally, commodity price increases combined with debt de-leveraging pressures form a toxic combination for the US consumer. Real disposable income is no longer growing in the US, as labour market income growth and fiscal stimulus do not offset the squeeze from higher oil and food prices.

In contrast, households’ real disposable income in Germany is still rising; their savings buffer remains extraordinarily high and has probably more chances of being put at work in view of the buoyant domestic sentiment. The strength of household balance sheets is a key differentiating factor across economies in an environment of rising interest rates, slower growth of real disposable income and pressure for fiscal consolidation.

The combination of real interest rates and current account balances points to broad dollar weakness. In other words, yields do not offset the external risks associated with the dollar. With the recovery, the trade deficit of the US has widened again to about 3.4% of GDP on a 12-month basis. The bilateral deficit with China accounts for more than half of the US trade deficit and cannot be blamed on CNY undervaluation alone: much of that deficit is concentrated in a few products, first and foremost laptops. Structural shifts may be needed to boost long-term growth. US exports going to the BRICs represent only 12% of total exports (or about 1% of GDP). The Eurozone is better geared to this group of fast growing economies, with exports to the BRICs accounting for 14% of total extra Eurozone exports (or about 2.3% of Eurozone GDP).

In addition to the ability to increase export capacity, the potential for the US to attract stable external financing is key to make it sustainable to run a current account deficit above 3% of GDP, as is currently the case. In the recovery phase, net portfolio inflows to the US have however been unusually subdued. The still large basic balance deficit at -2% of GDP (taking into account the sum of the current account balance, net foreign direct investment and net portfolio flows, excluding US Treasuries) highlights the lack of fundamental support to the broad dollar index.

In sum, we believe the complacency of investors towards the dollar is unwarranted, in view of the US structural imbalances and disappointing growth performance. This realisation may not take a tail risk event to unfold, such as the US missing a payment over a few days as the debt ceiling approaches. But macro trends should be enough to point to that direction, as higher real interest rates and/or a weaker dollar on a broad basis are needed to reduce the twin deficits over time.

Claire Dissaux is Managing Director, Global Economics & Strategy with Millennium Global Investments Ltd, a specialist currency and alternative investment manager. The views and opinions expressed in this article are those of the author and do not necessarily represent the opinions of Millennium Global Investments or any of the funds/accounts it manages or any of its portfolio managers.

^{1. IMF, World Economic Outlook, various issues, and United States: Selected Issues, July 2009; EU Commission, Economic Forecasts Spring 2009, European Economy, 03/2009; EU Commission, European Economy, Impact of the current economic and financial crisis on potential output, Occasional Papers 49, June 2009; The effect of financial crises on potential output: new empirical evidence from OECD countries, D. Furceri and A. Mourougane, OECD Working Papers, May 2009.}

2. See for example IMF Working Paper, Has the Great Recession Raised US Structural Unemployment? – May 2011

3. See the analysis of Robert F. Martin, Federal Reserve