I have to admit that the accelerating fall of the unloved U.S. dollar along with recent pronouncements from the administration have taken away any remaining support from even the most die hard of dollar bulls such as yours truly. On the one hand, very large positive carry is embedded in long dollar positions. As an example, two-year treasuries currently yield in excess of 2%, while both two-year German Bunds and two-year Japanese government bonds (JGBs) yield minus 0.60% and minus 0.15% respectively. On the other hand, the signal by the treasury secretary that a weak dollar is in the best interest of the United States due to increased trade benefits makes explicit what currency speculators have been anticipating since the Trump victory – that a weak dollar is desirable in an “America First” policy environment. We are all mercantilists now, I suppose.
For market participants, this raises the bigger question of how large debts and deficits are dealt with, and hence has significant ramifications for not only the currency, but also the bond markets and by extrapolation the equity markets, credit and housing.
The United States has trillions of dollars of debt held by creditor countries and the dollar discussion brings to the fore how this debt will be settled when it comes due.
A debtor has four ways of settling what he owes a creditor. First, the debtor can “grow” out of the debt. The hope is that economic stimulus from exports that follow a short-term weaker dollar will be sufficient to generate revenues to pay the coupons and principal over time. Whether the U.S. can grow quickly enough in the medium-term to become a net creditor seems very unlikely given that new deficits will result from the recent tax cuts.
A second way of settling what is owed a creditor is by defaulting on the debt. Given the right of the sovereign to print more dollars, we can safely assume that the United States will not take this route and will pay off the face value of the debt as it comes due.
Devaluation of the dollar is the third option. If the dollar is devalued, then the real value of the debt declines.
Finally, and related to the devaluation “option,” is deflation of the debt by creating inflation. Rising inflation reduces the terminal value of the obligations, i.e. it “deflates” the real value of the payables. Deflating the debt by creating inflation thus “kills softly”, but for all practical purposes is also a default on obligations that is spread out over many years. Devaluation thus reduces the value of the obligations not by outright refusal to pay, but rather by payment in a future currency that is worth much less than its value today.
First, since most of the fixed income obligations that will suffer due to the pernicious devaluation sit in the coffers of foreign central banks, they are likely to feel more immediate pain than US investors, who will likely see pain only gradually through rising interest rates and yields, and decreased purchasing power as the bonds mature. It is anyone’s guess whether foreign investors would continue to hold instruments whose real value can easily and quickly erase the “carry”. It would be a fair bet that they would want to wait and see if the weak dollar rhetoric is temporary, rather than a permanent change. But waiting is expensive, since new debt will need to be issued and bought, presumably at higher yields and lower prices. Indeed, while it would be rational to wait and see, the risks are large enough that they are likely to be less patient.
So from this perspective, we would expect the weak dollar to allow for an acceleration of the bond bear market. In our view, holding long bonds with yields less than 3% in an environment of rapid dollar devaluation simply does not make sense unless one needs these bonds for immunization of long term liabilities, or unless one hedges the risk through currency options. And as we have discussed in previous posts, given the very low levels of currency option volatility, some investors may indeed be able to hedge the currency risk while keeping their treasury holdings. But even as large as it is, the currency options market is not large enough to hedge every holder of treasuries. There is enough evidence to suggest that the negatives simply keep piling up against US bond duration, so we would not be surprised to see investors and market participants who choose to go neutral or underweight the intermediate to long end of the US bond market.
Second, if yields rise rapidly on the back of a falling dollar, equity markets are likely to come under pressure. The last decade has seen a correlated rise in the value of all assets as yields have fallen, and the effect of cheap money has raised discount factors, which has boosted the value of all investment assets. As this story runs in reverse, an already high equity market could be exposed to sharp corrections that are correlated with the bond market. In other words, diversification may not work as well as investors expect. If the bond market selloff is a bond market crash, one should expect bond market volatility to spike, which would filter into rising volatility for all other markets. In the worst case scenario, this could trigger a coordinated risk reduction across markets as correlation assumptions come to the fore.
Finally, rising yields will likely result in credit markets competing with sovereign bond markets for the marginal investment dollar which will be offering a higher risk-free yield. Hence, credit spreads would be expected to widen, which in turn, would exacerbate and amplify the negative feedback effect on equity markets. The weakest credits would eventually feel the effect of high financing costs and the quiet devaluation could ultimately lead to actual defaults increasing.
The story is likely to be more positive for real assets like housing and land. A weaker dollar, if not accompanied with capital controls, would lead to an inflow of money into this country to buy such assets at a discount.
Having observed policymakers jawboning a “strong dollar” for over 20 years, the recent preference for a weaker dollar is a significant and consequential change for markets. As global investors parse the implication of this potentially major policy change, wise investors who don’t absolutely need these long maturity bonds will probably not wait for the exit door to get too crowded.
Any views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the views of LongTail Alpha, LLC, its affiliates or other associated persons thereof.