Is this the end of the Dollar as we know it?
In 2020, our vocabulary expanded to include the words, COVID-19, lockdown, Dr Zweli Mkize, vaccine etc. What we have also learned is to keep a careful eye on the market. Since COVID and global economic catastrophes, the economy worldwide has been recovering at a faster rate than initially anticipated. This is especially true in manufacturing.
During the Great Financial Crisis of 2008 and the recovery thereof in the years after, there was a massive hole in nominal GDP and an output gap to match, as such, significant and ongoing policy support was needed. The same holds true today. However, if some manufacturing capacity should be destroyed forever, the output gap might be deceptive. Regrettably, the room for policymakers to ease financial conditions is very limited. Although a collapse in US Treasury Yields has significantly helped ease financial conditions, going further, the risk is that further quantitative easing could push bond yields higher. As such, fiscal policy must fill the gap.
During the 1960s, the FED implemented loose fiscal policy along with tight monetary policy, and it ultimately led to the failure of the Bretton Woods system. For us, however, the most important question to ask is how fast and how far the dollar falls? The bond yields that will be needed to organically match Treasury demand, along with the exploding supply would simply be too destructive for the dollar (see the graph below).
We are of the belief that the FED would have to underwrite the bond market, eventually, which will cause their balance sheet to explode. If the FED chooses to underwrite government spending (as in the 1960s), the dollar will take the strain.
Back then, the dollar fell 50% vs the Deutschemark and Yen. This time around, it could be worse as the US’s debt is mainly held by China. We are also of the belief that the bond market is completely mispriced, should there be a spike in yields, a risk correction will be triggered.
In terms of FX, questions arise as to whether the ECB and Bank of Japan would let their currencies rise. However, they have very little ammunition to prevent the dollar from weakening, and they will ultimately gain from the reflation that dollar weakness will bring. The three most sensitive EM ETFs to the dollar are Brazil, South Africa and Mexico. Remarkably, they stack up flawlessly with the terrible performance of their currencies since the dollar based in 2011 (see the graph below).
We have seen massive outflows and sell-off in Bond markets from emerging markets with a flight to “safe haven” currencies and commodities at the start of the pandemic. In South Africa’s case, we have also seen the downgrading of the country by rating agencies.
The question that is on the table is that with the anticipated US dollar weakness, what would be the effect be on the Rand? This is where the waters get a bit muddied, to say the least. On the one hand, we expect the US dollar to underperform quite spectacularly if our scenario plays out and this could be the shot in the arm that the Rand needs to have a significant appreciation against the US dollar.
However, and there has to be one, as we alluded to in the above paragraph South Africa suffered another round of downgrades recently, our house is not in order, and this will have more of a longer-term impact on the Rand. The masking agent at the moment is the COVID pandemic with most of the world going through a bit of strife. It could dampen any significant Rand weakness in the short term as the world start up again, but in the longer term when the COVID fog lifts, the South African bare bones will be laid bare, and the Rand could lose the benefit of a weaker US dollar, due to local issues.
It is worth stating that we might have experienced the equivalent to the 1918 Spanish flu, with similar policy easing, and we might just be entering the analogue of the “roaring 20s”. However, this time, Asia will be playing the part of the US. It will be the Asian decade. Given this scenario, the US would tremendously underperform.
Our final thoughts are that, if investors buy into the whole COVID story, very few are fully positioned for it, if at all. We believe that investors might, at this stage, only have a fraction of the EM and commodity exposure they want. If we are right, these moves have barely even started. As we can see from the graphs below, USDZAR has been trending downwards since we saw R19.35 in April 2020. If the whole USD weakness story plays out a move back to R14.00 is not beyond the realms of possibility.
USDZAR for 2020
EURZAR for 2020