U.S. dollar downslide: Are we at a tipping point?

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Shaun Osborne: Welcome to Market Points. I'm Shaun Osborne, Managing Director and Chief Currency Strategist at Scotiabank.

Over the last decade, the U.S. dollar has sustained considerable strength, but recently we've experienced what looks to be the start of a pretty significant reversal. Is the turning point real? And if it is, how low can we go from here? And what will be the implications for the Canadian dollar and Canadian investors?

With me from the currency desk is Eric Theoret. Eric, welcome to the podcast and welcome back to Scotiabank.

Eric Theoret: Great to be back and excited to get into it.

SO: So, I just wanted to start off with an interesting quote I read recently from Yannis Stournaras. This gentleman is the head of the Greek Central Bank and a and European Central Bank Governor. He was interviewed in The Economist recently and said this, “The Trump administration has injected a level of uncertainty into the international monetary system that global investors can no longer ignore by eroding free trade, shaking global alliances, undermining the independence of the Federal Reserve and threatening to weaponize the dollar for political purposes, it has prompted the world to question whether the dollar is still a safe bet.”

So, we're recording this on May 29^th, and I think that kind of sums up the challenges for investors at the moment.

We've seen the dollar start the year on a pretty soft footing. We're down about 4% in the first quarter. It's one of the worst starts of the year for the dollar index I think in 10 or so years. We've seen another pretty significant fall in the dollar since then, the dollar index is now down around 8% year to date.

So, a lot of volatility in the markets, and curiously, we're still kind of tracking that first Trump experience as well where the dollar rallied at very early in the first term and then proceeded to weaken quite significantly of the balance of the first Trump term.

But it seems to us that, we are looking at a pretty significant challenge for the dollar going forward from a number of different fronts, and one of the first issues that I wanted to talk about was the dollar’s valuation.

As I mentioned in the intro there, the dollar's been on a bit of a tear over the last decade probably more than that, probably more like 15 or so years since the end of the financial crisis, we've seen a significant appreciation in the value of the dollar over that period. And looking back over the last 10 years or so, the dollar index is up around 30% in real effective terms.

It's one of the strongest major currencies in the world at this point. And I think there are a number of questions started to be raised across markets and by investors, in fact, as to whether this situation is sustainable.

Valuation's a bit of a, a nebulous concept. I know, and I'm reminded of the quote again by John Maynard Keynes, the famous quote that markets can remain irrational for longer than you and I can remain solvent. So, I think, you know, valuation is always something of a subjective issue, but by many, many measures, the dollar is really stretching the boundary.

And that overvaluation seems particularly acute against emerging market currencies. But it's also quite relevant against some of the developed market currencies as well. So, Bloomberg at the start of the year estimated that the dollar was around 15% overvalued against the euro, around 12% overvalued against the yen and the pound sterling. And I noticed a report just over the past week from KKR suggesting that in their view, the dollar was around 16% overvalued in broad effective terms.

So, a lot of work has been done, I think, on trying to study the dollar's valuation at this point. And it kind of coincides with some of the work that we've done at Scotia looking at the dollar’s performance from a long run point of view, looking at the 20-year moving average of the dollar. And how over the course of the last 30 or 40 years, looking at standard deviations we can see that dollar cycles typically start to flag around about that two standard deviation point. Now the dollar index was around two standard deviations above its 20-year moving average a couple of years or so ago. We've seen essentially a bit of a range trade in the dollar since the peak, but we're still trading very close to that two standard deviation level.

The two standard deviation point was a cap for the dollar. In previous cycles, it's also been the low point or caught very close to the low point for the dollar, so it strikes me that from a statistical point of view, there's quite a body of evidence here, long run evidence, to suggest that the dollar is very close to a longer run peak. And that we're looking at a situation here over the course of the next maybe 5 to 8 years from a long run point of view, a little beyond the kind of horizon of our sort of formal forecast at the moment, where we are looking at the potential for a pretty significant decline in the dollar to unfold going forward.

So given the, the situation that we've seen in terms of the dollar’s relatively extreme valuation, I think those concerns that we're seeing emerge over the last few months about the outlook for the dollar given the policies that we're seeing pursued in the U.S., these issues become, I think, a lot more relevant for investors as they consider the outlook for the U.S. dollar that may be a longer term net negative and something else that's emerged recently and that's the issue of de-dollarization.

ET: When we look at the concept of de-dollarization, you know, we are currently and have been in a world where the U.S. dollar retains a very high share of use in terms of global transaction volumes, things like that are measured by the Bank of International Settlements, even holdings of international foreign exchange reserves as measured by the IMF’s data as well. And so, I think when we think about the high share that the U.S. dollar has in both I think investment denomination and also global financial transaction volumes there really, really is only one kind of direction to go, which is, you know, putting the balance of risk for the U.S. dollar as being tilted to the downside.

You know, I think given the makeup of the global trade and financial system and the U.S. administration's pursuit of more balanced trade, that does introduce a bit of a challenge as well for, you know, trading partners that have typically recycled their surpluses into U.S. denominated assets.

And so, I think a world where these trading partners might have a bit more of a complicated time in recycling those surpluses, you know, that might be the piece that actually hits before even the rectification or the rebalancing of trade in that, you know, that U.S. dollar investment recycling flow would actually get interrupted first.

And I think that's something that we've seen in the markets, certainly with the price volatility in the treasury market and as well, I think just the U.S. dollar's response to trade headlines.

I think when it comes to de-dollarization, and just I think global geopolitical developments as well, even just calling into question the reliability and accessibility of FX reserves, the rewriting of financial contracts and debt instruments in the Euro crisis, Russia's challenges, at least when it relates to the war with Ukraine, and the I guess the nationalization or clawing back of the FX reserves that they were holding in Western financial systems. You know, these are all prompting countries to shift their capital flows and reconsider their allocation in terms of FX reserve balances. And so, I think, you know, in a world of rising geopolitical tensions, this is a world where countries will potentially choose to bypass not only the U.S. dollar, but many of the, I think, consistent or current reserve currencies that, that we've kind of typically accepted.

SO: Yeah, so I think one of the issues that we've seen before is that the challenges have been that there is no alternative, the old TINA argument that it was pretty much unavoidable to not be invested in the U.S. dollar, at least to some extent from a global reserve manager point of view.

But we have seen the emergence of a number of different avenues for investors and purchasers to channel payments and invest their surpluses recently. So, we've seen the emergence of alternative payment systems particularly in China, for example, as a challenge to the sort of SWIFT organization. We've seen the emergence of gold in particular as an alternative investment for sovereign reserve managers who are trying to avoid increasing their exposure to the U.S. dollar. We've seen the emergence of crypto as well, potentially as another avenue. So, is this maybe the first real cracks we've seen in the sort of dollar dominance of the global financial architecture?

ET: Yeah, it certainly feels as though we've reached, I guess a zenith in terms of, you know, the U.S. dollar's use in the global financial system. And I think from here it won't be so much of an absolute decline as just a dilution in terms of the greater volume of transactions, whether it's you know, bypassing the U.S. dollar in terms of trade volumes or in financial systems and use of alternative payments to the SWIFT system. You know, I think again, it won't be an absolute decline, but very much a relative dilution for the U.S. dollar going forward, and we're just going to be living in a bigger world where the U.S. dollar is a smaller part of it.

SO: Right. Almost a passive shift.

ET: Yes.

SO: In the sense that there won't be an active move away from the U.S. dollar. It will just be a gradual shift as alternatives present themselves going forward.

Alright, so I think to advance the discussion a little bit more, we can talk maybe about some of the structural challenges facing the U.S. dollar right now.

And this is another issue that has emerged, not necessarily out of the blue, but maybe crept up on markets. We're in a situation now where combined deficits in the U.S., that's to say fiscal deficits and the current account deficit, equate to around about 10% or so of GDP. So outside of the blow up in the budget deficits that we saw in the pandemic, that's the biggest combined deficits that we've seen in, again, a number of years going back to the probably 2010, 2011 period.

Double digit deficits typically a point, I think, where investors start to pay a little more attention to fiscal dynamics in particular. And obviously with President Trump's tax bill progressing through Congress slowly at this point, but still progressing through Congress, there's even more concern about the potential buildup for even larger debt and deficits in the U.S. going forward. And again, historically looking at the performance of the U.S. dollar against these combined deficits over the course of the last 30 or 40 years, it does appear to me as if we're at a point where these deficits may start to weigh on dollar sentiment. We're at a point where historically I think currency markets and interest rate markets maybe have become a lot more sensitive to the deficits in fiscal policy in the U.S.

So, we do appear to be in a situation where, as we've seen recently, markets can have a disciplining effect on errant fiscal policy, shall we say? We saw a brief example of that maybe in April when President Trump unveiled the round of very aggressive tariffs that did spook a very significant drop in the U.S. Treasury market. A lot of volatility obviously in U.S. assets generally. But the drop in the bond market did appear to be one thing that prompted President Trump to maybe dial back the tariff threat.

We've seen other examples of that in recent economic history as well. Back in 2022, for example, in the UK the Truss government, of the day, announced a range of unfunded tax cuts, which the markets didn't take too currently to. They didn't like the math of the Truss government's fiscal policies. That triggered a very significant sell in the pound sterling. Also, immense volatility in the UK government bond market, which entailed the intervention or necessitated the intervention of the Bank of England to try and stabilize the bond market.

So, there is this notion of the bond vigilantes may be starting to saddle up again to try and exert some influence over U.S. fiscal policy. It seems unlikely, I think in the short run at least that we'll see any modification in the big, beautiful tax bill that President Trump wants to pass through Congress.

But this bill clearly will see a pretty significant deterioration in U.S. fiscal policy settings by most estimates. The Trump team would argue that there's a significant growth benefit going to come from reducing taxes, which will compensate for, or at least help partially fund some of these tax cuts.

It's not obvious from history though, that trickle-down economics really has the kind of benefit that they may be hoping for. And it strikes me that we may be in a situation where investors will start to require or demand some sort of concession, either in the form of high yields to compensate for the increased risk that they're running by holding U.S. treasury debt, or in the form of even a lower U.S. dollar to make those assets cheaper to purchase in a sense.

Or it may be a combination of both, and we have actually seen the emergence of that kind of trend actually emerge over the last little while where we've seen the U.S. dollar weaken along with rising treasury bond yields, which is pretty unusual for the U.S. dollar. And it does suggest that there is a lack of faith perhaps at this point in U.S. fiscal policy.

I think government bond markets clearly can wield a lot of power and they can have a quite a significant disciplining effect on government policy as I mentioned. But we may need to see a bit more volatility, high yields or a lower U.S. dollar before that actually becomes a factor that this U.S. administration has to consider.

ET: Well, it certainly has been interesting to hear you speak of the disciplining aspect of markets and specifically the instance of the UK government and the market really introducing that concept of market discipline in terms of fiscal space and, and how governments have to really have an engagement with markets in order to determine how much or how little fiscal space they do have. I think you know, beyond the fiscal situation the trade policy is another major piece for the administration.

You know, I think the last six months have been very instructive in the sense that we've had, quite a bit to observe in terms of the market's reaction to, I guess the, the introduction of Liberation Day or at least the concept of it back in February which was generally I think what we would've seen as a kind of textbook risk off U.S. dollar positive reaction. But since then, it feels as though we've had a bit of a reversal in the U.S. dollar's reaction to trade headlines.

And so, the introduction of this piece of uncertainty now emanating from the U.S. which even, you know, in the past was not a kind of precursor to U.S. dollar weakness. We do have a very clear relationship now between this U.S. risk and the reaction for the U.S. dollar. And so, it does feel as though, you know, tariffs on, are a negative for the U.S. dollar.

Is that something that you would say we've observed as well?

SO: Yeah, I think you know, markets are looking at a situation where particularly high tariffs would be stagflationary and clearly something that would not be good for the U.S. economy. So, now that situation's may be modified with the news that we've had just over the last few hours that the court challenge to some of President Trump's tariffs has been held up.

So that means that we’re back to a situation of somewhat lower tariffs and maybe a bit more manageable in terms of the tariff hit that some economies are expected to take. And, and the impact on prices and growth in the U.S. may be somewhat less. But I, I think the other consideration on this particular issue is that this is going to roll out now over the next few weeks or months as it runs up the appeals process, or the President chooses to adopt other tariff measures to compensate for the tariffs that have been blocked by this court judgment.

So I think in a sense it's out the frying pan into the fire from a macroeconomic point of view, at least in the short run because the potential slowing of the economy that we were expecting to see from this tariff hit, may now come from the uncertainty aspect of not knowing where we really are or where we're going to be in terms of tariffs which is going to delay hiring, delay investing, and generally keep the economy in the U.S. and probably elsewhere running at a pretty soft pace over the next few quarters.

ET: We are in a world where, you know, typically the standard textbook reaction would be, well, a weaker currency helps countries get export share and kind of onshore economic activity. Given the changes in the global economy and the reallocation of manufacturing and industrial physical assets, could we find ourselves in a world where, you know, a weaker U.S. dollar would not be enough to entice the reshoring that the U.S. administration is looking for?

SO: Well, firstly, I'm a little surprised that the administration hasn't already pulled on the exchange rate lever to try and achieve some of the goals that they want to achieve.

We know there are certain figures within the administration, even President Trump himself has mentioned that he has certain problems with some exchange rates that he deems to be far too low and in need of a revaluation, particularly referring to some of the currencies in Asia.

But we know other administration officials, JD Vance has talked about the high value of the dollar and the impact that's having on, has had on manufacturing in the U.S. I'm firstly a little surprised that we haven't seen maybe a bit more attention paid to the exchange rate angle of this debate.

Whether we could see the dollar decline to a point where it would facilitate that kind of onshoring or rebalancing of global trade, difficult to say in the short run, but clearly a very significant decline in the value of the dollar, in the relative short term, would force international manufacturers to, I think reconsider where they're producing goods and will certainly make U.S. exports much more attractive and raise the price of imports from Europe and Asia. So, I think that is one aspect, one probably relatively unspoken aspect, of this effort to try and rebalance U.S. trade that the administration is undertaking. If we see more roadblocks put in front of the administration from the courts, from challenges to tariffs, it may well be that the exchange rate becomes a more visible part of the process that the administration pursues to try and achieve some of its goals.

So, we've got here a situation where we're looking at structural issues, cyclical issues, we've got President Trump's trade policies that we think are going to be negative for the U.S. dollar, we've got this valuation concern that I think is particularly relevant. And it all seems to be pointing towards a weaker dollar in the longer run.

So, I'm going to ask Eric the question that clients always ask us when we're doing these kind of presentations, that's all well and good, but what if you're wrong? Where might we be wrong in terms of this analysis? And where could things actually turn in favour of the dollar actually staying relatively strong or even strengthening even further?

ET: Well, I think, you know, one of the major pieces that we've seen kind of break in this latest period of trade policy has been the break with fundamentals.

And so, we do have a world where a lot of exchange rates that typically trade on interest rate differentials are just, you know, completely dislocated to those models. And we are also living in a world where the Federal Reserve I think is holding a bit more firm relative to the U.S. President in his calls for lower interest rates.

So, should we find ourselves in a world where the Fed really does hold on to their, you know, independence and I guess what would be on a global basis, a relatively more hawkish stance, you know, that's a world where we could see, at least in the very short term, a U.S. dollar that goes much higher.

SO: I guess one of the other things that we need to at least consider is that the Trump team might well be right about all of this and that massive tax cuts will boost growth and perpetuate that kind of dollar outperformance, that story of U.S. exceptionalism, that has been really the underlying pillar of the dollar strength of the past decade.

I think the proof will be in the longer-term pudding. Unfortunately, we won't know essentially whether, whether we're going to get there in terms of a sustained burst of growth driven by tax cuts, we won't know that for quite some time. But it's certainly something that we, that we need to consider.

So, I guess just to round things out, we should talk about you know, what this actually means in concrete terms for the dollar going forward because the dollar has moved very, very quickly, it's not just our forecast that look a little bit stale at the moment. I just did have a quick look at the consensus forecast before we jumped into the recording studio here.

There aren't any forecast looking for dollar Canada to push under 130 in the next 12 to 18 months. And that may well be something given some of these considerations that we're talking about here: the fiscal worries, the trade and tariff policies that the U.S. administration is pursuing, the structural concerns, the valuation issues that may well be something that we have to start to factor in as a risk to our longer-term views.

So, dollar Canada, on a 120 handle? We haven't seen that in quite some time. But something in the region of 125 to 130 in the context of the, some of the challenges that we're talking about over the next couple of years is something I think is potentially quite reasonable as a view. Now whether the U.S. dollar weakens much beyond that or weakens more quickly going forward, that's to be determined. But I think we are in a situation where given with that, we've seen this relationship between the Canadian dollar and assets, risk assets, break down a little bit over the course of the last few months, a persistent strengthening in the Canadian dollar in an environment where risk assets tend to underperform, that would be quite meaningful for Canadian institutional investors because of the reliance that Canadian investors generally, not just institutional investors, but retail investors and institutional investors are heavily exposed to U.S. asset markets.

We generally, typically see in times of market volatility, equity market declines tend to be offset in terms of Canadian returns for investors here in Canada. In terms of equity market volatility, U.S. returns for Canadian based investors do tend to be cushioned by the exchange rate move.

That's to say a somewhat stronger U.S. dollar in response to weaker global stocks. But if we see this relationship turn, as we've seen maybe the inklings of in the last little while, then potentially we could see a situation where Canadian investors get hurt relatively more by a situation where equity markets weaken and the Canadian dollar strengthens in response to that.

So that's something I think investors need to be cognizant of as a risk going forward.

ET: Yeah, I agree very much. I mean, the, the, the concept of equity returns being negative in both U.S. dollar terms and also on a currency adjusted basis is quite concerning.

SO: Alright, Eric, this has been a great discussion. Thanks very much for coming along. Let's do it again soon.

ET: Thanks very much for having me. I look forward to the next conversation.

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