USD
By: Ben Mcdonald
Tags: Debt, Equity, Regulation, Us Dollar, Investing

The US Dollar is on a bit of losing streak since April. Indexed against other reserve currencies, the Dollar is down close to 10%. Sentiment has shifted heavily against the greenback as a new wave of speculation that the role of the US Dollar as the world’s reserve currency is coming to an end due to huge fiscal deficits and more generally a decreasing favorability of the country.

I think these concerns are way overblown and are not backed up by any real data. It’s important first to note that the US Dollar is the global currency of choice and it’s not even close. Over 50% of cross border loans are in US dollars. Over 50% of cross border trade is in USD. Over 80% of FX volume has the Dollar on one side of the trade. When you have a natural monopoly on global trade, the barriers to entry are extraordinarily high.

The US Dollar is favoured by the international community for many reasons, but why it became the favoured currency is a bit of the chicken and the egg problem. It likely started because the US was an economic powerhouse in the 20th century. US financial institutions were ahead of their time and made international trade and borrowing easier by having branches in foreign countries very early on. Many were comfortable owning USD as they felt it wouldn’t be inflated away and that the US government would never default on their obligations. Now it’s a little like Microsoft Office: everyone knows how to use it and knows that everyone else uses it, so it’s just easier to keep using it.

It continues to be the currency of choice because it’s very easy borrow, even if you aren’t domiciled in the US. It’s also easy to hold onto USD due to international US Dollar financial institutions and the safety and stability of US Treasuries. As long as corporations and institutions continue to borrow, save, and spend in USD, the US Dollar will continue to be the reserve currency. You can see below that foreign lending of US Dollars is not slowing down by any means.

The investment implications from this are extremely important, especially from a Canadian standpoint. Equities tend to do poorly when economic activity slows. When economic activity slows, corporations have less revenue but similar expenses. When profits fall, the need to borrow increases. When the need to borrow increases, the need for US Dollars increase. When the need for US Dollar increases, the US Dollar tends to rise. This provides a natural hedge to equity market risk.

Interestingly, this effect has become much stronger since 2008. The chart below shows 3 month returns of global equities on x-axis and the change in exchange rate between CAD and USD (rising means the USD is appreciating) from 1994 to 2007. You can see there’s a bit of relationship but not huge.

Now look at the same data except from 2008 until now. Look at how much stronger the relationship has gotten. When 3 month returns were negative, it was almost automatic that the USD would appreciate.

Why is this happening?

After 2008 there were significant regulations that came into effect including Basel III (an international accord to limit leverage and increase liquidity of banks) as well as Dodd-Frank (a US bill that limited prop trading in banks). Both of these created significant limitations on the balance sheet of US banks. When there are limits on US bank balance sheets, there are limits on the amount of US dollars that are available. While the Fed can create unlimited dollars, the Fed’s only real conduit to get those dollars out is through the banks. If those banks have leverage limits, that transmission mechanism is significantly weakened.

This year almost became another financial crisis, not because the banks borrowed too much, but because the couldn’t borrow enough. If banks can’t expand their balance sheet to extend loans to corporations and institutions that need money, those corporations and institutions have to start selling assets to meet their obligations. The issue compounded because when these corporations and institutions went to sell their bonds, the buyer (aka their dealer) was under leverage constraints and couldn’t expand their balance sheet to buy them!

The great irony of the post-2008 regulatory efforts is that they tried to make the financial system more stable, but it some ways it made it more fragile. Leverage constraints have meant that bond markets are probably less liquid in times of stress as there’s not really a natural counterparty to buy bonds when everyone is selling. This is a big reason why the Fed stepped in to buy bonds from banks.

The upshot of this is that there’s tons of value in having US Dollar (and other reserve currency) exposure in portfolios. As long as financial institutions have leverage constraints, and as long as the US Dollar is the currency of choice for foreign intuitions and corporations to trade, borrow, and save, there should be a natural hedge that occurs in times of stress. Given that fixed income yields are so low, creating a large drag on target returns, we need to be more creative in how we manage risk in client portfolios. From a Canadian perspective, exposure to USD is a great way to do that.