Don’t wait for the US Dollar Rally, its Already Happened


“Don’t cry because it’s over. Smile because it happened.” – Dr Seuss


“Republicans are for both the man and the dollar, but in case of conflict the man before the dollar.” – Abraham Lincoln


“Dark economic clouds are dissipating into an emerging blue sky of opportunity.” – Rick Perry


According to the minutes of the Fed’s June meeting, released on Thursday, some companies indicated they had already “scaled back or postponed” plans for capital spending due to “uncertainty over trade policy”. The minutes added: “Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.”

Despite the concerns around tariffs, the minutes also revealed that the Fed remained committed to its policy of gradual rate hikes and raising the fed funds rate to its long-run estimate (or even higher): “Participants generally judged that…it would likely to be appropriate to continue gradually raising the target rate for the federal-funds rate to a setting that was at or somewhat above their estimates of its longer-run level by 2019 or 2020”.

The somewhat hawkish monetary policy stance of the Fed combined with (i) expectations of continued portfolio flows into the US due to the interest rate differentials between the US and non-US developed markets, (ii) fears of the Trump Administration’s trade policies causing an emerging markets crisis, and (iii) the somewhat esoteric risk of ‘dollar shortage’ have led many to conclude that the US dollar is headed higher, much higher.

Of all the arguments for the US dollar bull case we consider the portfolio flows into the US to be the most pertinent to the direction of the greenback.

According to analysis conducted by the Council of Foreign Relations (CFR) “all net foreign demand for ‘safe’ US assets from 1990 to 2014 came from the world’s central banks”. And that “For most of the past 25 years, net foreign demand for long-term U.S. debt securities has increased in line with the growth in global dollar reserves.”  What the CFR has described are quite simply the symptoms of the petrodollar system that has been in existence since 1974.

Cumulative US Current Account Deficit vs. Global Foreign Exchange Holdings1aSources: Council on Foreign Relations, International Monetary Fund, Bureau of Economic Analysis


In recent years, however, global US dollar reserves have declined – driven by the drop in the price of oil in late 2014 which forced the likes of Norges Bank, the Saudi Arabian Monetary Agency, and the Abu Dhabi Investment Authority to draw down on reserves to make up for the shortfall in state oil revenues – yet the portfolio flows into the US continued unabated.

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings and comparing it to the cumulative US Treasury securities issuance (net), it is evident that in recent years foreign central banks have been either unable or unwilling to finance the US external deficit.

Cumulative US Marketable Treasury Issuance (Net) vs. US Treasury Major Foreign Holdings1Sources: US Treasury, Securities Industry and Financial Markets Association


Instead, the US has been able to fund its external deficit through the sale of assets (such as Treasuries, corporate bonds and agency debt) to large, yield-starved institutional investors (mainly pension funds and life insurers) in Europe, Japan and other parts of Asia. The growing participation of foreign institutional investors can be seen through the growing gap between total foreign Treasury holdings versus the holdings of foreign central banks.

US Treasury Total Foreign Holdings vs. US Treasury Major Foreign Holdings2Source: US Treasury


Before going ahead and outlining our bearish US dollar thesis, we want to take a step back to understand how and why the US was able to finance its external deficit, particularly between 2015 and 2017, despite the absence of inflows from its traditional sources of funding and without a significant increase in its cost of financing. This understanding is the key to the framework that shapes our expectations for the US dollar going forward.

We start with Japan. In April 2013, the Bank of Japan (BoJ) unveiled a radical monetary stimulus package to inject approximately US dollars 1.4 trillion into the Japanese economy in less than two years. The aim of the massive burst of stimulus was to almost double the monetary base and to lift inflation expectations.

In October 2014, Governor Haruhiko Kuroda shocked financial markets once again by announcing that the BoJ would be increasing its monthly purchases of Japanese government bonds from yen 50 trillion to yen 80 trillion. And just for good measure the BoJ also decided to triple its monthly purchases of exchange traded funds (ETFs) and real estate investment trusts (REITs).

Staying true to form and unwilling to admit defeat in the fight for inflation the BoJ also went as far as introducing negative interest rates. Effective February 2016, the BoJ started charging 0.1 per cent on excess reserves.

Next, we turn to Europe. In June 2014, Señor Mario Draghi announced that the European Central Bank (ECB) had taken the decision to cut the interest rate on the deposit facility to -0.1 per cent. By March 2016, the ECB had cut its deposit facility rate three more times to take it to -0.4 per cent. In March 2015, the ECB also began purchasing euro 60 billion of bonds under quantitative easing. The bond purchases were increased to euro 80 billion in March 2016.

In response to the unconventional measures taken by the BoJ and the ECB, long-term interest rates in Japan and Europe proceeded to fall to historically low levels, which prompted Japanese and European purchases of foreign bonds to accelerate. It is estimated that from 2014 through 2017 Japanese and Eurozone institutional investors and financial institutions purchased approximately US dollar 2 trillion in foreign bonds (net). During the same period, selling of European fixed income by foreigners also picked up.

As the US dollar index ($DXY) is heavily skewed by movements in EURUSD and USDJPY, the outflows from Japan and Europe into the US were, in our opinion, the primary drivers of the US dollar rally that started in mid-2014.

US Dollar Index3Source: Bloomberg


In 2014 with Japanese and European outflows accelerating and oil prices still high, the US benefited from petrodollar, European and Japanese inflows simultaneously. These flows combined pushed US Treasury yields lower and the US dollar sharply higher. The strong flows into the US represented an untenable situation and something had to give – the global economy under the prevailing petrodollar system is simply not structured to withstand a strong US dollar and high oil prices concurrently. In this instance, with the ECB and BoJ staunchly committed to their unorthodox monetary policies, oil prices crashed and the petrodollar flows into the US quickly started to reverse.

Notably, the US dollar rally stalled and Treasury yields formed a local minimum soon after the drop in oil prices.

US 10-Year Treasury Yield4Source: Bloomberg


Next, we turn to China. On 11 August 2015, China, under pressure from the Chinese stock market turmoil that started in June 2015, declines in the euro and the Japanese yen exchange rates and a slowing economy, carried out the biggest devaluation of its currency in over two decades by fixing the yuan 1.9 per cent lower.  The Chinese move caught capital markets by surprise, sending commodity prices and global equity markets sharply lower and US government bonds higher.

In January 2016, China shocked capital markets once again by setting the official midpoint rate on the yuan 0.5 per cent weaker than the day before, which took the currency to its lowest since March 2011. The move in all likelihood was prompted by the US dollar 108 billion drop in Chinese reserves in December 2015 – the highest monthly drop on record.

In addition to China’s botched attempts of devaluing the yuan, Xi Jinping’s anti-corruption campaign also contributed to private capital fleeing from China and into the US and other so called safe havens.

China Estimated Capital Outflows5Source: Bloomberg


The late Walter Wriston, former CEO and Chairman of Citicorp, once said: “Capital goes where it is welcome and stays where it is well treated.” With the trifecta of negative interests in Europe and Japan, China’s botched devaluation effort and the uncertainty created by Brexit, capital became unwelcome in the very largest economies outside the US and fled to the relative safety of the US. And it is this unique combination, we think, that enabled the US to continue funding its external deficit from 2014 through 2017 without a meaningful rise in Treasury yields.

Moreover, in the absence of positive petrodollar flows, we suspect that were it not for the flight to safety driven by fears over China and Brexit, long-term Treasury yields could well have bottomed in early 2015.


Investment Perspective


  1. Foreign central banks show a higher propensity to buy US assets in a weakening US dollar environment


Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings, we find that foreign central banks, outside of periods of high levels of economic uncertainty, have shown a higher propensity to buy US Treasury securities during phases of US dollar weakness as compared to during phases of US dollar strength.

Year-over-Year Change in Major Foreign Holdings of Treasury Securities and the US Trade Weighted Broad Dollar Index 6Sources: US Treasury, Bloomberg


The bias of foreign central banks, to prefer buying Treasury securities when the US dollar is weakening, is not a difficult one to accept. Nations, especially those with export oriented economies, do not want to see their currencies rise sharply against the US dollar as an appreciating currency reduces their relative competitiveness. Therefore, to limit any appreciation resulting from a declining US dollar, foreign central banks are likely to sell local currency assets to buy US dollar assets. However, in a rising US dollar environment, most foreign central banks also do not want a sharp depreciation of their currency as this could destabilise their local economies and prompt capital outflows. And as such, in a rising US dollar environment, foreign central banks are likely to prefer selling US dollar assets to purchase local currency assets.


  1. European and Japanese US treasury Holdings have started to decline


European and Japanese US Treasury Holding 7Source: US Treasury


The ECB has already scaled back monthly bond purchases to euro 30 billion and has outlined plans to end its massive stimulus program by the end of this year. While BoJ Governor Haruhiko Kuroda in a testimony to the Japanese parliament in April revealed that internal discussions were on going at the BoJ on how to begin to withdraw from its bond buying program.

In anticipation of these developments and the increased possibility of incurring losses on principal due to rising US inflation expectations, it is likely that European and Japanese institutional investors and financial institutions have scaled back purchases of US dollar assets and even started reducing their allocations to US fixed income.


  1. Positive correlation between US dollar and oil prices


One of the surprises thrown up by the markets this year is the increasingly positive correlation between the US dollar and the price of oil. While the correlation may prove to be fleeting, we think there have been two fundamental shifts in the oil and US dollar dynamic that should see higher oil prices supporting the US dollar, as opposed to the historical relationship of a strengthening US dollar pressuring oil prices.

The first shift is that with WTI prices north of US dollar 65 per barrel, the fiscal health of many of the oil exporting nations improves and some even begin to generate surpluses that they can recycle into US Treasury securities. And as oil prices move higher, a disproportionality higher amount of the proceeds from the sale of oil are likely to be recycled back into US assets. This dynamic appears to have played out to a degree during the first four months of the year with the US Treasury securities holdings of the likes of Saudi Arabia increasing. (It is not easy to track this accurately as a number of the oil exporting nations also use custodial accounts in other jurisdictions to make buy and sell their US Treasury holdings.)

WTI Crude vs. US Dollar Index8Source: Bloomberg


The second shift is that the US economy no longer has the same relationship it historically had with oil prices. The rise of shale oil means that higher oil prices now allow a number of US regions to grow quickly and drive US economic growth and job creation. Moreover, the US, on a net basis, spends much less on oil (as a percentage of GDP) than it has done historically. So while the consumers may take a hit from rising oil prices, barring a sharp move higher, the overall US economy is better positioned to handle (and possibly benefit from) gradually rising oil prices.


  1. As Trump has upped the trade war rhetoric, current account surpluses are being directed away from reserve accumulation


Nations, such as Taiwan and the People’s Republic of Korea, that run significant current account surpluses with the US have started to re-direct surpluses away from reserve accumulation (i.e. buying US assets) in fear of being designated as currency manipulators by the US Treasury. The surpluses are instead being funnelled into pension plans and other entitlement programs.


  1. To fund its twin deficits, the US will need a weaker dollar and higher oil prices


In recent years, the US current account deficit has ranged from between 2 and 3 per cent of GDP.

US Current Account Balance (% of GDP)9Source: Bloomberg


With the successful passing of the Trump tax plan by Congress in December, the US Treasury’s net revenues are estimated to decrease by US dollar 1.5 trillion over the next decade. While the increase in government expenditure agreed in the Bipartisan Budget Act in early February is expected to add a further US dollar 300 billion to the deficit over the next two years. The combined effects of these two packages, based on JP Morgan’s estimates, will result in an increase in the budget deficit from 3.4 per cent in 2017 to 5.4 per cent in 2019. This implies that the US Treasury will have to significantly boost security issuance.

Some of the increased security issuance will be mopped by US based institutional investors – especially if long-term yields continue to rise. US pension plans, in particular, have room to increase their bond allocations.

US Pension Fund Asset Allocation Evolution (2007 to 2017) 10Source: Willis Tower Watson


Despite the potential demand from US based institutional investors, the US will still require foreign participation in Treasury security auctions and markets to be able to funds its deficits. At a time when European and Japanese flows into US Treasuries are retreating, emerging market nations scrambling to support their currencies by selling US dollar assets is not a scenario conducive to the US attracting foreign capital to its markets. Especially if President Trump and his band of trade warriors keep upping the ante in a bid to level the playing field in global trade.

Our view is that, pre-mid-term election posturing aside, the Trump Administration wants a weaker dollar and higher oil prices so that the petrodollars keep flowing into US dollar assets to be able to follow through on the spending and tax cuts that form part of their ambitious stimulus packages. And we suspect that Mr Trump and his band of the not so merry men will look to talk down the US dollar post the mid-term elections.



This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Japan: Bullish Because Of Not In Spite Of Demographics

“The aging and decreasing population is a serious problem in many developed countries today. In Japan’s case, these demographic changes are taking place at a more rapid pace than any other country has ever experienced.” – Toshihiko Fukui, the 29th Governor of the Bank of Japan


“I have experienced failure as a politician and for that very reason, I am ready to give everything for Japan.” – Shinzo Abe


“Here is the reality of Japan’s demographic crisis: at eight births per 1,000 people, Japan’s birthrate in 2013 was among the lowest in the world. Meanwhile, the proportion of the population over 65 is now 25%, the highest in the world. In 2010, Japan’s population peaked at 128 million. Current projections show the population dropping below 100 million by 2048 and as low as 61 million by 2085. The country’s working-age population has been declining since the late 1990s, making it increasingly difficult to care for Japan’s retirees.” – Saskawa Peace Foundation USA


Japanese stocks are breaking out (have broken out?). Irrespective of which measure of market performance you prefer, the TOPIX or the Nikkei, the recent performance of Japanese stocks has been impressive. And, if you are wondering, it is not because of a weakening yen.

Tokyo Stock Price Index (TOPIX)topix

Source: Bloomberg

Nikkei 225 Indexnikkei

Source: Bloomberg

Japan’s demographic challenge is well-documented. More than a quarter of the population are 65 years old or older. Birth rates are at record lows. And since one of the market truths many of us have come to know and accept is that “demography is destiny”, we know that Japan’s economy will only continue to struggle. With the prevalence of this type of thinking, it is no surprise that many have been confounded by the recent rally in Japanese stocks.

Channelling our inner Charlie Munger we inverted and asked ourselves: under what scenario would Japanese-style demographics be the precursor to an economic boom? In our attempts to answer this question we have to come to the conclusion that the Japanese economy is quite possibly on the cusp of a virtuous growth cycle because of demographics not in spite of them.

We arrived at this conclusion due to one simple reason, we think that the Japanese economy is well-placed to lead and reap the benefits of the coming robotics revolution. Concurrently, Japan’s demographic challenge means, while the country is not entirely immune, it is uniquely sheltered from the potentially negative socio-economic consequences that may arise from the increased proliferation of robotics and artificial intelligence. (We have previously articulated some of our concerns around the unbridled development of artificial intelligence in Artificial Intelligence and Meaningful Work.)

Unemployment is low. Labour force participation levels are high. The overall population is declining while the elderly population is increasing and the labour force dwindling. Corporates are hoarding cash – companies listed on the Tokyo Stock Exchange just set a new record –their cash holdings are now more than 140 per cent of Japan’s GDP. The enormity of the level of cash holdings is better appreciated when compared to the 43 per cent of US GDP equivalent held in cash by US corporations – this 43 per cent includes the much talked about cash held offshore by the likes of Apple and Microsoft.

Japanese Unemployment Rate (%)unemployment

Source: Bloomberg

Japanese Labour Participation Rate (%)labour participation

Source: Ministry of Internal Affairs and Communications

The confluence of all these factors makes Japan ripe for the uptake of robotics to really accelerate but for one missing ingredient: capital investment. Although there is some evidence of capital investment picking up, Japanese companies have continued to demonstrate high levels of restraint when it comes to capital spending.

Despite the investment restraint shown by corporations, necessity, invention and a focused robotics strategy introduced by the government in 2015 – New Robot Strategy – has already positioned Japan at the forefront of the robotics revolution. We think there are a number of factors that will push Japanese corporations towards increasing capital investment and lead them to aggressively adopting robotics and artificial intelligence.

During the campaigning for the recent elections, opposition leader Yuriko Koike – governor of Tokyo and former Minister of Defense – called for a punitive tax on corporate cash reserves in order to encourage companies to invest more. While Koike’s new Party of Hope was resoundingly thumped by Prime Minster Abe’s Liberal Democratic Party (LDP), Koike’s criticism of corporate cash hoards resonated with members of the LDP. The government of Japan, we expect, will exert increasing amounts of pressure on companies to force them into spending their cash piles by increasing capital investment and paying higher wages.

When President Trump came into office he promised to shake up global trade in order to put America first and cut the US trade deficit. He brought in global trade hawks – Secretary of Commerce Wilbur Ross, Director of the White House National Trade Council Peter Navarro, and Trade Representative Robert Lighthizer – to form part of his administration. To date, very little of note has been achieved by the Trump administration on the trade front. With Trump also having failed to deliver on the domestic policy front, however, we think he will seek to overcompensate by taking a more aggressive stance on US trade policies. Especially as the president has the power to levy trade tariffs on countries without needing approval from Congress. More importantly for Japan, however, we think the Trump administration is also likely to become more aggressive in calling out countries they deem to be “currency manipulators”. And with the yen significantly undervalued in terms of its real effective exchange rate, there is little room for the Bank of Japan to talk down the yen. Moving forward, Japanese companies are unlikely to be able to rely on an undervalued currency to drive exports. Quality and sophistication – two traits that have traditionally been the hallmarks of Japanese products – will have to come to the fore. And that requires capital investment and potentially re-shoring of some manufacturing capabilities back to Japan.

The Chinese government’s strategic plans are progressively more focused on increasing local consumption and having much more of its population employed in higher-paid positions. This requires Chinese businesses to move up the value chain. And it is in response to such government objectives that industrial companies in China have started to move into the production of higher-value added goods – venturing into territories normally occupied by Japanese companies. As the threat from China intensifies, Japanese industrials will have to respond by increasing the complexity and quality gap between them and the competition. The Japanese, however, do not have the luxury to call upon a deep pool of labour. They instead will have to invest in robotics and automation if they are to have a chance of staving off the Chinese threat.

Given all the above factors, we think it is not a question of if but when Japanese companies will start increasing capital investment. And we think that the time has come.

Japanese Industrial Production vs. the Unemployment RateIP vs UnemploymentSources: Ministry of Economy Trade and Industry, Bloomberg


Investment Perspective

Corporate profits as a share of GDP, in Japan, are making new highs. Higher profits combined with high levels of cash and low levels of leverage encourage companies to undertake capital expenditures. Capital expenditures increase private sector profits and create demand for credit to the benefit of banks. Et voilà, a virtuous economic cycle.

Japan Credit to Private Non-Financials (% of GDP) vs. TOPIX IndexTopix vs Private Credit

Sources: Bank for International Settlements, Bloomberg

While not so simple, Japan indeed is on the cusp of a virtuous private sector profit cycle. So the question to our minds is not whether one should have an allocation to Japan or not but rather should the allocation be currency hedged or not. And to do that we say, ignore those calling for the yen to 200 and do not hedge. On a real effective exchange rate basis, the yen is significantly undervalued.

 Japanese Yen Real Effective Exchange RateYen REER

 Source: Bank for International Settlements

While this is a broad market call, we do want to highlight two sectors – one to overweight and the other to avoid. One of the sectors we are most bullish on in Japan is the healthcare equipment and services sector comprising of companies such as Olympus Corporation and Terumo Corporation. Japan is at the forefront of elderly patient care – its population has the longest average lifespan in the world. Healthcare equipment and services providers in Japan have supported the Japanese healthcare sector in facing the challenges posed by a rapidly aging population by delivering cutting edge solutions. As the US and Europe increasingly face up to the demographic challenges Japan has already gone through, there is an inevitable opportunity for Japanese healthcare equipment and service providers to increase their global reach and grow their exports to the US and Europe.

The one sector that we prefer to avoid in Japan is the financial sector. If a capital investment cycle kicks-off in Japan, as we expect it to, Japanese companies do not need to borrow – they are already sitting on so much cash – and this perhaps means that this spending will not automatically lead to an increase in demand for credit and nor does it imply that a meaningful rise in interest rates will be forthcoming.

We are long the iShares MSCI Japan ETF ($EWJ) as well as a select number of healthcare equipment and services providers.



This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.