An unstable currency equilibrium | Insight Investment

Good morning everybody.

Today I would like to pick up on some of the comments that Adrian made around the instability and equilibrium that is unstable within markets and really very much focus down on what is happening in the FX space, which we believe is one of those places where we have an unstable equilibrium.

So one of the things that's I think good to set the picture is to go back to the annual investment update that we had last year where we spoke about a number of turning points and points of, of instability within US policy in particular. So last year we spoke about discontinuity in trade and immigration policy, in fiscal policy, which Adrian has picked up on, and most recently geopolitical events have come to the fore even more.

Now with the benefit of hindsight, if you were to go back to to last year, we probably should have added the fifth bullet point, which is the pressure on the orthodoxy of a number of US institutions. Now the important point is that the Fed tends to be at the forefront of this risk of higher unorthodoxy, but the Fed is not the only institution in the US that's under pressure. And if you pick up a newspaper in the US or look at the news, you can see how this unorthodox developments are starting to spread well beyond the central bank.

And so a combination of all these factors have understandably led a number of investors to ask the question, are we seeing the beginning of the demise of the dollar as a safe haven currency and as a risk as a reserve currency of the world?

Now if you look at the markets, the markets over the last 12 months or so have definitely been flagging, red signals. And you can see this on the chart on the left hand side that looks at the returns of a number of different assets over the past 12 months. The one that sends out by far the most is gold, which has gone up almost 90% in the space of 12 months, which is pretty remarkable by any standards.

But that worry of general orthodoxy and policy discontinuity in the US is something that has also spilled into the FX space. So the Swiss Franc is up almost 18% in the last 12 months. The euro almost 15% and even Sterling that's had his fair share of, of structural issues has managed to irk out around 10% increase. And so there's definitely something that the markets are telling us.

So what do we think of this and where, what impact do we think this is going to have in the markets?

Now our general sense is that these are genuine worries that we're going to need to think about and take into account when we form portfolios. But the real big question for us is whether we are likely at a tipping point where things move very, very quickly or whether this is something that is likely to be a slow effectively decline of dollar supremacy, particularly when looked through the lens of of the FX reserve status that it has.

So to answer the question, we've done a little bit of homework. So we've looked at the currencies that we think are the potential candidates to take or to benefit from a loss of reserve status from the dollar. So we looked at Euro, Sterling, Yen and the Chinese remimbi and then we thought about what are the key characteristics that are needed to be considered a reserve currency, be given reserve status.

And we think that they fall broadly speaking into three categories. So economic relevance, you can't have a reserve currency for a country that is not a significant part of the global economy. liquidity also very, very important. And then the third point is the risk property. And when we talk about risk property, we mean how do the different assets behave in risky or in challenging environments? So what you want is for a reserve currency to maintain its value when the world is at most uncertain.

And then we've looked at a number of different manifestations of that. So the percentage of each of the countries, so the GDP within global GDP, percentage of invoicing, we looked at market capping, equities, bonds, variety of different things. And then we ranked the currencies that we looked at.

And one of the things that comes out when you do this exercise is that for all of the noise and all of the worrying, the dollar still scores up at the top, which doesn't mean that we're saying that the dollar doesn't have an issue, but it means more importantly that you know, the famous constant of Tina, there is no alternative. It is very difficult. Even if you want to divest completely from all of those dollars that you hold as as a reserve manager or as you know, as as a reserve status, and you want to diversify and bring them someplace else, it is very difficult to do so.

And so the way that we think about some of the structural challenges that the dollar faces is that it's much more likely to be a gradual erosion of that dollar supremacy within the reserve status base rather than a tipping point.

And in a way, if you compare it back to history, this is much more akin to what happened to Sterling at the beginning of the last century. So if you go back in time, what you find is that the economic relevance at the global stage of sterling declined far faster and quicker than when sterling losses is reserve status, which happened really around the, the second world war of last year. So we kind of view a similar, downward trajectory.

So one of the key questions for us, and this is where we kind of tie it back to what we think about markets, not, you know, in five years time or 10 years time, but over the next sort of 12 months, when you think about the currency space, there are two things that you need to keep in in mind.

The first one is some of the structural worries. And we've just spoken about those and we've said that we do have a lot of sympathy for for those concerns. And we're not the only ones. So what we show here is the dollar share of FX reserves. And as you can see, they've been on a downward trend for quite some time. It's been a slightly more accelerated trend since the GFC, but it's a story that is not a new story, that kind of gradual decline of the dollar as a reserve and as a safe haven has been playing out.

But that's only part of the story. When you think about where the dollar and currency markets are gonna go over the next 12 months, you have to have a view on the cyclical part. And if you look again with a bit of hindsight, the cyclical support for the dollar has been extremely strong. So as much as ethics reserve managers have been shedding dollars, the cyclical support for the US economy has been extremely strong.

And so what we show here is the relative performance of the S&P versus the MSCI world. And you can see the extensive outperformance that US assets have had. The truth of it is that even if you take a GDP, you do the same dark green line with the GDP, you find the same thing. So that cyclical support for the US has been extremely strong and has to some degree counterbalance some of those structural worries.

And so when you think about the outlook for the dollar over the next 12 months, you have to keep in mind the structural, but you have to have a view on the cyclical.

So what are the things that matter and what are we looking at for the cyclical support?

There's really two key things that matter for currencies. The first one is the global backdrop. ideally what you want is a healthy global backdrop where the US is not outperforming significantly. And again, this is something that Adrian alluded to. We do have a bit of that global backdrop.

And the second part is relative monetary policy. Now the two things are somewhat linked, but they're a little bit different. And so the second point is really how does the Fed's policy relate to those of other central banks? And Harvey will, will talk a little bit more in in detail about this.

So what do these two factors tell us about the cyclical support for currencies over the next six to 12 months?

As I mentioned, the backdrop is actually pretty supportive for some moderate dollar weakness. Again, this is a similar chart to the one that Adrian showed. This is the world composite PMI. And as you can see, it's not at the highs of where it's been, but it's still pretty healthy. It's significantly above what historically has been considered the boom and bust line.

And most importantly, the dollar isn't really shooting or the US economy isn't really shooting the lights out in the same way that it has. So what the chart on the right shows you is that same PMI. But instead of looking at at the global, you look at the US versus the rest of the world and you quite clearly see that we had a period not so long ago in which the US was massively outperforming. Now that period has gone away.

So if you were to look at where we are now, this is a pretty conducive environment for a bit of dollar weakness. The challenge that we need to flag is particularly on the chart on the right hand side, that relative economic performance, there are risks to that. So if you look in the next three to six months, you're likely to see a US economy, which is actually has a fair amount of of support and that comes in the form of some of the payback from the government shutdown that we had late last year. But also, and possibly most importantly, the fiscal support that's likely to come through the one big beautiful act.

And so there's some question marks in terms of is the US economy going to start to perform better than it has because of these two cyclical factors? And so we would say that it's a conducive backdrop to a bit of dollar weakness, but there are risks to this.

The second factor, which is very important is the point around how does the Feds and monetary policy in the US compared to the rest of the world. And what we show here on the right hand side is the two year government yield of the US versus the rest of the world. And you see quite clearly that we're well off the highs. And so there has been a significant repricing of expectation and an interest rates, against the dollar. And that's one of the things that has helped this year to, in addition to some of the structural headways that we spoke about. But that's one of the things that also helped the dollar come under pressure this year.

And so if you look at where we are right now, you're well off the highs and so it's a less big hurdle to beat short dollars, but you're nonetheless facing some pretty positive carry if you're actually long dollars, which basically means if you flip it the other way around that if you want to be short dollars, it's gonna cost you and it's gonna cost you perhaps not as much as it did a few years ago, but still a pretty significant amount.

And this is relevant not only for investors that look at currency space as a, an investment opportunity, whether you look at carry or kind of whatnot, but it's also very crucially very important for the hedging behavior, which is one of the topics of the last 12 months.

Because of the structural issues that we spoke about, there's been a lot of discussions around everyone has a lot of dollar assets, they've held usually a fair amount of dollar exposure along with it. Do you actually, is this a good time to, to start to hedge?

And this interest rate differential is very important in that decision because when you hedge, particularly if you're hedging US assets, you're effectively buying or you're investing in the interest rates of your local currency and you are effectively being exposed to the carry cost of the US. And so this interest rate differential whereby to be short dollars, it's costly plays out not just in the investment side but also in the hedging decisions. And this is something that's, it's a big, even though it's not quite as strong as it was before, it is one of the factors that does actually support the dollar.

Slightly different way of looking at it is to say, okay, well this is where we are right now. Where do we think we're going to go?

And so what we show on the chart on the right hand side is what we as insight expect in terms of monetary policy. And again, I think Harvey's going to to cover a little bit more detail. And so we compare what we expect in terms of monetary policy versus what the market is pricing.

And so as a house, we do expect the Fed to cut rates a couple of times this year, which in theory should help, should help that two year differential move lower. The challenge is that so does the market. And so what we show on the right hand side, that little orange bar is the difference between what we expect versus the market, which effectively tells you that the market already prices in some degree of expectations of Fed cut. So it's not completely obvious that this chart on the right hand side going forward is going to go much beyond where it is at the moment. And so this part here within that cyclical aspect is actually giving you some support.

So up to now we've spoken a lot of of different factors, some up, some down. So how do we net it together?

So one of the key things that we use is this ethics scorecard that I show on the right hand side. So what we do is we have a number of structural factors and a number of cyclical factors and then we net them together. And as you can see from the legend, we tend to give more weight to the cyclical simply because historically that's tended to be the key driver, but the structural also has, has a key, sort of plays a key role.

So when we look at this and we do this across all the different currencies that we monitor, there's a couple of things that I think stand out.

The first one, and perhaps surprisingly if you look at Sterling, it actually scores pretty well. and if you look at that breakdown, yes it does have some structural headwinds which I think we're all aware of, but crucially, those structural headwinds are less, for example, than those of the, of the dollar. And so the cyclical support that Sterling is getting by virtue of the fact that the economy has turned out to be more resilient than we thought and that the interest rate that the central bank, the Bank of England hasn't cut as much as people feared at the beginning of last year, is actually putting Sterling in not a bad position.

So that's the first point.

The second point is we move over to the dollar and there's a couple of interesting things on this. The first one is that whilst the score is actually neutral relative to everybody else, you're kind of in the wrong side of the distribution. It's not terrible, but it's certainly not great either with the exception of three other currencies. Most of the other currencies are actually giving you a better score.

And most importantly, when you look at that zero neutral score, what you see quite clearly is that tug of war between the cyclical which is supportive that we spoke about, and the structural, which is very negative, which I think to us this means that there is this inherent tension between these two big boulders that are pushing in opposite directions that are leaving the dollar in a very unstable equilibrium.

And the point that I would also make is the cyclical part, which is the blue bars is integrally linked into the central bank outlook. So when we look out to 2026, we think the central banks are gonna play a very important role in the currency market simply because that cyclical factor is holding up a lot of positive. It is kind of balancing a lot of negative on the, on the structural side to the point of these two boulders pushing in in opposite direction.

and this again is something that picks up on what Adrian has said. This is just a very simple chart of of the dollar over the last, 12 months. And I think it highlights quite nicely how this tug of war between the cyclical and the structural has actually played out.

So if you look at the beginning of last year, what you see is that the dollar came under pressure. There's a little bit of liberation day, there's a lot of expectations of rate cuts starting to come in. So the Fed cut three times last year. And so this is where the market started to, to become more or priced at in more.

But what's interesting is that from liberation day on these two big tugs of war have effectively led to an incredibly long and somewhat frustrating if you invest in in currencies, sort of pretty, pretty limited amount of, of of movement that you've seen. So very, very stable currency space.

And again, it's interesting that when we did this presentation, it was before last Friday, or we were putting it together before last Friday, and what you notice is in the last couple of days you started to to break between outside of that range. And that's because there's been increased worries around does the dollar, does the US administration want a weaker dollar? There's, you know, the Federal Reserve tapped, uh, sort of did a rate check on on Dollar-Yen in sort of the markets in, in New York time on Friday. So this is a very unstable equilibrium that it doesn't take very much to break you out of it.

So what, what are the thoughts that we'd like to leave you with? because we talked about a whole bunch of different things sometimes going in opposite direction.

So there's really two key messages that we'd like to leave you with.

The first one is that we do expect the dollar to, to go lower. We don't expect it to be a crash because particularly some of those structural concerns are likely to be more of a slow burn. but there are two key risks that we need to acknowledge.

The first one is that the US economy may well continue to surprise it, certainly surprise in 2025, it may well do so this year as well. And so that's kind of the, the first key risk around, sort of around that, that bearish dollar view.

The second one, which has become particularly clear in the last few months is the geopolitical risk. It's a wild card, not just in terms of what events we're likely to have, but because there's so much noise around it, it actually makes it quite difficult to know how you are supposed to trade some of these events.

So that's something that we'd be very careful about, but we do expect the dollar to go lower.

The second point is this point around the instability of the equilibrium. You know, we, we showed the chart, of the dollar in the last year where you had very tight ranges.

I think the chart on the right hand side is, is incredibly interesting, at least if you're an FX person. what we show here is the ranges in Eurodollar and some of the dollar crosses going back to when currencies floated. So 50 years ago. And the interesting thing is where that little orange circle is, those are the ranges where we've been in the last six months.

So you are basically in the fourth percentile of tight ranges going back to the 1970s, which is a pretty remarkably tight sort of range of outcomes.

Now again, part of that is due to that type of war between the cyclical and the structure, which is kind of keeping us stuck. But the point that I would make is that if you look at that chart, you don't end up staying at, there's low level of volatility of ranges very long. And when you do, you quite frequently snap back extremely aggressively.

And so we would caution against the complacency that the dollar hasn't gone anywhere. It probably means that it won't go anywhere in the future because that stability hides a lot of tension under the surface.

And so if you have foreign assets, for an investment, our point is you want to be careful around your lingering currency exposure because if we're right and we start to snap back out of these currency ranges, these tight ranges that could have a meaningful impact on your portfolios.