All Hail King Dollar!
Posted on 27 March 2015
"Predicting currency markets is a viciously difficult task – it makes the search for the Higgs-Boson particle look easy."
One of the ideas we advanced in the Investor Notebook, which appeared in the Outlook edition of Compass, was that diverging central bank policies would have an impact on currencies. The idea was simple: money follows growth and interest rates. In the case of the former, the US market continues to be the beacon of growth, and in the case of the latter, each new day is one closer to the end of the Federal Reserve’s Zero Interest Rate Policy (“ZIRP”).
Investors I talk with are increasingly interested in knowing how long a strong dollar environment will prevail. Predicting currency markets is a viciously difficult task – it makes the search for the Higgs-Boson particle look easy. Currencies, like gold, have no intrinsic cash flow that can be used to derive a price. They are a medium of exchange or sometimes a store of value – though in the age of fiat currencies, not a very good one. When it comes to currencies, identifying the trend is probably more important than hitting the target. It is the former that is the subject of our examination.
How long can the strong dollar environment prevail? It is an important question, given the role of the dollar as the global reserve currency. The Bank of International Settlements (“BIS”) calls the dollar “the dominant vehicle currency,” since it is involved with 87% of foreign exchange transactions. Moreover, the dollar has maintained this level of dominance for roughly the last 17 years.
An enduring question in the post-financial crisis age is, when will the dollar lose its perch as the world’s reserve currency to the yuan, the euro, or a basket of BRIC (Brazil, Russia, China, India) currencies? The answer appears to be no time soon, according to the BIS data. The currencies that rank two through seven collectively make up 86.6% of foreign exchange trading, and the BRIC currencies collectively constitute 5.9% of global trading. The threat to King Dollar, if there is one, is not imminent.
Furthermore, as interest rate differentials widen, the potential asset liability mismatch that exists from non-US companies carrying dollar liabilities has the potential to be the equivalent of a financial boomerang. These liabilities were likely incepted when the greenback was under the pressure of quantitative easing and ZIRP. To dimension the size of the potential problem, at the end of September 2014, non-financial credit extended to firms outside the United States stood at $9.2 trillion. This constituted a 9% increase over the prior year and a 50% increase since 2009. Consequently, the question of how long a strong dollar regime will last and how high can the currency rise against its peers is a subject that has interest far beyond the faculty lounge set.
 Source: Triennial Central Bank Survey, Foreign exchange turnover in April 2013: preliminary global results. Bank of International Settlements.
 The dollar likely has enjoyed this level of dominance for a considerably longer period. The period cited reflects the data available through the BIS website. Triennial Central Bank Survey, Foreign exchange turnover in April 2013: preliminary global results. Bank of International Settlements. (www.bis.org
 “Greenback” is foreign exchange slang for the dollar. Its origins stem from the paper currency printed during the Civil War.
 Global liquidity: selected indicators (www.bis.org
), as of February 28, 2015.
Hans Olsen, CFA Global Head of Investment Strategy