Although the US short-term interest rates are moving higher than those of other major economies, the almighty currency hasn't responded to that fact as strongly as one would expect. The US dollar Index (NYSEARCA:UUP) trades much lower today than the 100+ peak level it has reached twice last year, even though its underlying fundamentals seem to be improving, in anticipation of an accelerating US economy. The only way this strange USD behavior can be explained is if the rapidly deteriorating US debtor situation is taken into account. A ballooning negative net international investment position (NIIP) of the US economy, fueled by its persistent current account deficits, outbalances any positive support the US dollar might expect from the rise of interest rate differentials. This threatens the global reserve currency's leadership role for the first time in decades.
Interest rate support
The 3-month USD Libor rate has broken to the upside, extending the uptrend that begun last year, and reached its highest value since the end of the Great Recession. Absolute figures aside, the relative distance between USD and EUR Libor rates is the largest it has been in 9 years. This is happening at a time when the monetary conditions between the US and the Eurozone economies are diverging. While the ECB continues to deploy its QE program, FED is laying down the groundwork for rate normalization. The same diverging pattern is observed between USD and GBP 3-month Libor rates. Trying to counteract the repercussions of the Brexit vote, the BoE dropped interest rates and expanded its asset buying program. An even bigger divergence exists between USD Libor rate and its yen and Swiss franc counterparts. This comes as no surprise, due to the expansionary monetary policies of these two creditor economies. Another factor supporting the dollar is the bear steepening of the US yield curve, adjusting to expectations about rate normalization. All these developments would normally boost the USD against its major peers, and establish a solid revaluation trend, since higher real yields from USD assets would ultimately attract capital flows from competing markets. However, this has not been the case so far, and it begs the question, why?
The USD repercussions of the US Debtor Status
The most substantial reason keeping the greenback from soaring is the deteriorating debtor position of its economy. This, coupled with the loss of competitiveness, has caused the US FX market to lose critical capital inflows. The US economy is also experiencing a worsening trade and current account deficit, while at the same time witnessing renewed inflationary pressures. These types of inflating current account deficit economies often experience an abrupt currency weakness, ignoring the supporting interest rate differentials. The US dollar index - a weighted average of the dollar's value with respect to the Euro, Japanese yen, Pound sterling, Canadian dollar, Swedish krona, and Swiss franc - seems to be trapped within a major sideways formation, leaving it significantly lower than its 12-month highs.
The debtor situation of the US economy is not only deteriorating but it is doing so in a rapid pace. As of Q1 2016, the total deficit of the US NIIP ballooned to -7.5 trillion USD, a staggering increase of 651% in 16 years. This gap was powered, mainly, by the great imbalance between its portfolio investment liabilities and its portfolio investment assets. In other words, more US assets are acquired by foreign holders than foreign assets acquired by US holders. This creates powerful ramifications for the US dollar. As the USD gets more expensive, each dollar earned is worth more in foreign currency terms, meaning that the desire for foreign holders to repatriate each dollar only grows bigger. This ultimately increases the demand and capital inflows to foreign currency, effectively removing support from the dollar. Currently the USD trade weighted index (TWI) has increased by almost 27% during the last 5 years, even though it still rests 18.5% below its 2002 peak and 34% off its 1985 all-time highs. The difference, though, between the 2002 and 1985 peaks, in comparison to the current USD TWI levels, is the size of the NIIP. Today, more US assets are in the hands of foreigners, than ever before. As its NIIP goes deeper and deeper into the red, the USD price required to overturn the positive flows into negative ones, is being lowered more and more. For this reason, the USD TWI level today is not comparable to the same level a couple of decades ago, meaning that its current state is more worrisome even though its absolute figures might not seem so elevated.
Apart from its debtor situation the US also has to worry about its loss of competitiveness. During the last couple of years, US exports have followed a strong downward trend, in contrast with fairly stable exports for the Eurozone, Japan, and China. The inability of US exports to follow their main peers' trajectory, combined with the USD TWI appreciation, point to a serious overvaluation of the US dollar. Additionally, if the current macro indications and market expectations, which are pointing towards a US recovery, materialize, then a new abnormality may occur. While the domestic demand for imported goods and services would increase, US exports would not be able to follow the at the same pace. This would potentially enlarge the US trade deficit and bring more negative flows to the USD. The world could witness a booming economy with the most unresponsive currency. All these reason are truly threatening the leadership role of the USD, a role that hasn't been challenged since WWII.
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