The U.S. Dollar, The Key To The Future?

by: John M. Mason

Summary

Especially since Brexit, the value of the US dollar has strengthened. The primary reason being the uncertainty connected with the meaning of British exit for the UK and the EU.

Given the global presence of the dollar as a safe haven for risk averse funds, the value of the dollar can serve as a focal point for understanding world emotions.

As with the European financial problems in the 2011-2013 period, the financial flows are also taking the yield on the Treasury Inflation Protected Securities in or near negative territory.

In the Tuesday Financial Times, Jennifer Hughes follows former Secretary of the US Treasury John Connally and makes the suggestion "watch the dollar, not sterling."

This suggestion is made in the shadow of the referendum just completed in Great Britain in which the British voted to "exit" the European Union and the massive decline in the value of the British pound.

The reason for this is twofold: first, the US dollar is a global currency; and the movements in the foreign exchange markets are primarily a result of risk aversion.

The first of these statements can hardly be argued with.

Ms. Hughes contends that the movement of funds around the globe as a result of the Brexit vote is due to concern over what will happen to Great Britain and to the economy of Great Britain, and to concern over what might result in the European Union facing not only the withdrawal of Great Britain from the EU, but also facing the possibility that the EU, itself, might fall apart as a consequence of British leaving.

One can certainly argue that the strength of the dollar has been a result of a flow of risk averse funds into the US, and other "safe havens" around the world.

Since the Brexit vote last Thursday, the yield on the 10-year US Treasury note has fallen from 1.73 percent at its close on last Wednesday, to 1.46 percent at the close of business on Monday.

The yield on the 10-year German bund, another "risk free" rate, fell from 10 basis points at the close last Wednesday, to a negative yield of 12 basis points on Monday. The yield on the 10-year Japanese bond fell from a negative 14 basis points on Wednesday to a negative 19 basis points on Monday.

In terms of impacts on foreign exchange markets, Ms. Hughes writes, "On Friday, the dollar rose against every major currency except the yen. Both benefitted from their status as havens in times of risk…." This performance also continued Monday.

We have seen this kind of behavior before during the period of extreme financial stress in European markets. The time frame was roughly the summer of 2011 through the summer of 2013.

This flow of funds to a "safe haven" can be shown in the fact that the yield on the 10-year US Treasury Inflation-Protected Security (TIPS) dropped off in early summer 2011 from about a positive 60 basis points to become negative for the first time in August 2011. The yield fluctuated around a zero yield until the middle of January 2012 when it became negative and stayed negative until early June 2013.

This period represented the time when the major flows of funds came into American financial markets. There had been early warnings about this flow as the yield on the fiver-year TIPS dropped into negative territory in late September of 2010 and remained in negative territory until September of 2014.

The yield on the 5-year TIPS dropped into negative territory once again in late February and early March of this year. This move coincided with the turmoil in world financial markets in January and February of this year. Note that at the start of 2016, the yield on the five-year TIPS was around 40 basis points.

The yield on the 10-year TIPS was around 80 basis point at the start of 2016, but by the first of March it had dropped to around 40 basis points.

At the beginning of June, the yield on the 10-year TIPS was around 25 basis points but it dropped precipitously in the first week of June. On June 8, the yield was just above 8 basis points.

I note the June 8 yield because on that date the dollar hit near-term lows against both the British pound and the euro.

Since June 8, the yield on the 10-year TIPs has remained near 8 basis points, closing there on Monday, as the value of both the British pound and the euro has dropped.

As with the 2011 to 2013 experience, it appears as if the flow of risk averse money started small and this was caught first by the drop below zero in the 5-year TIPS yield and then, as the flow increased, was reflected in the drop below zero in the 10-year TIPS yield.

It seems as if the same thing is happening today, and this flow of risk averse funds is impacting the value of the dollar against both the British pound and the euro.

The suggestion to watch the value of the dollar seems to be spot on because it seems to capture how risk averse funds are flowing throughout the world. The movement of funds can be confirmed by the drop in the yields on US inflation-adjusted securities.

The argument here is that the value of the US dollar will remain strong as long as uncertainty risk continues to be of primary concern to investors.

The reason it will remain strong against the British pound is obvious given all the uncertainty surrounding the real meaning of the British exit from the European Union and all that is connected with it.

The reason it will remain strong against the euro is that with Great Britain leaving the EU, there may be more to follow with Greece, Italy, Spain, and others raising issues of membership.

The US dollar will also remain strong against the currencies of emerging countries since so many of their economies are suffering problems of economic growth along with the strong dollar hurting their debt positions because so much of their debt is denominated in US dollars.

And, this strength seems to be outside the reach of what the Federal Reserve can do.

So, keep an eye on the dollar. It is likely to stay strong for the near future, and may strong even after this particular situation has passed. I still believe that global investors would still like to see a stronger dollar over the longer run. Whether or not US politics allows for this, however, is another question.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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