Israel has announced its intention to attack Iran. There have been increasing signs of this possibility for some time, and I pointed out the risk a few issues ago. I am beginning this issue with this announcement, although it does little to alter the fundamental economic developments. The USD remains in cyclical retreat. It is showing weakness against the rest of the world (RoW) in a variety of ways.
Given the prospect of a further sharp increase in the US government deficit, the weakness of the USD may well gain momentum.
Capital Flows are What we are Dealing With Here, Not Interest Rate Differentials!
The interest rate differential between the US dollar (USD) and the euro has grown significantly over the last six months, during which time the USD has weakened considerably. In these circumstances, anyone maintaining that high interest rates cause a strong currency must be accused of ignorance. Interest rates in Switzerland have returned to 0%, and a differential of more than 4% does not protect the USD from falling. The USD has also come under pressure against the Brazilian real and the Mexican peso since the beginning of the year (the Mexican peso only since April, but impressively so).
Although the stock markets in the USA have fully recovered after the slump in April, it is noticeable that this recovery has not led to a recovery in the USD.
Investors are Becoming Increasingly Distrustful of the US dollar
Although some foreign investment capital has returned to US stock markets, it is no longer willing to invest in the US without hedging the USD. Consequently, the USD has not only failed to recover, but has continued to decline.
The Hedging Ratio will Gradually Increase
Short-term decisions are not made in large-scale investment businesses such as pension and investment funds. However, the price of gold shows that currency developments should not be underestimated. The 29% increase in the price of gold this year has been offset by the depreciation of the US dollar, leaving investors in euros with a gain of just 113.5%. Unhedged US equities have also underperformed for euro investors since the beginning of the year. Last week, the German newspaper Handelsblatt recommended measures that ETF investors can take to remove the influence of investments in the MSCI World.
Do not underestimate the significance of this development. Foreigners hold more than 25% of American shares, equating to 50% of GDP, or USD 13.000 billion.
If only a small proportion of this substantial sum is hedged against the risk of USD devaluation, the USD will collapse because its triple deficit does not permit any other form of compensation.
Regardless of the USA’s Tariff Policy, a Strong USD Devaluation Would Be a Burden for Companies Outside the USA
Tariffs can be imposed erratically. If this happens, as is currently the case, the short-term nature of the tariffs makes them painful and unpleasant. What is currently happening is a sharp, lasting depreciation of the USD because the USD is deliberately losing its reputation as a strong currency. The rise in the US stock market in May has not enabled the USD to recover. Foreign asset managers are increasingly hedging USD risk. If this trend strengthens, as I expect it will, and investments become less one-sidedly focused on the US than they have been over the last 15 years (with 70% of global equity capitalisation in the US), the USD will automatically weaken. A 12% tariff burden would be ridiculous if the USD were to depreciate by 30–40% over many years. It is time to take this scenario seriously as a potentially existential threat. Unless, of course, you can find facts to suggest that the USD will remain strong and that the US wants it to. I don’t see any evidence of this; rather, the opposite can be argued with certainty.
