Ingrid
For decades, the U.S. dollar has been the world's currency anchor. But what if that anchor is starting to come loose? What would be the implications of a weaker U.S. dollar on markets and for investors? Today, I'm joined by one of my favorite guests, Kevin Hebner, U.S. strategist, to discuss a recent paper that he's written that theorizes a fairly significant and persistent shift to a weaker US dollar.
Kevin, let's dig in.
Kevin
Hey Ingrid!
Ingrid
Okay, compelling thesis here. Let's talk about it. Let's set the table for our listeners. And just what are we talking about? How significant a move are we talking about in the U.S. dollar?
Kevin
So, I think 15 to 20% from here, from now to the end of Trump's second term. So, an order of that magnitude.
Ingrid
Let's explore the why.
Kevin
So ultimately, what Trump is doing - his key economic objective is to rebalance the US economy and to reduce a lot of the imbalances, or rather the trade deficit, $1 Trillion, totally unsustainable. The US has offshored far too many industries, many of which have national security implications. These could include rare earths and critical minerals. Been in the news lately. Semiconductors, still chips.
Kevin
There's really tons of these. And none of these rebalancing or re-industrialization can occur with the dollar at the levels it is at today. We need to see a much weaker dollar for this to happen.
Ingrid
We often talk when we think about the US dollar as a sort of long-term reversion to mean that it sort of it moves in a range. What's different about this and why do we believe this time it's more of a persistent move?
Kevin
Yeah, so this would be similar to the big realignments we saw in the dollar one in 1971 under Nixon with the Nixon shock, a second in 1985 under Reagan with the Plaza Accord. In both cases, we had balance of payments, emergencies similar to today, and we had extremely overvalued currencies. And in both situations the dollar decreased in value by 20 to 30%, similar to what we're seeing in this cycle.
So, it's very similar, I think, to those two previous instances.
Ingrid
You talk in your article about the policy in the Mar a Lago Accord and specifically sort of four pillars of Catalyst. Yeah, Let's dig in a little bit on that.
Kevin
Yeah. So, the first argument is that the dollar is overvalued, and, in the paper, we talk about a couple of different valuation arguments. One, for example, is the Big Mac index, in which The Economist magazine looks at the cost of a Big Mac in 80 different countries. So, for example, it would be 20% more expensive in the U.S. than most other countries.
40% cheaper in Japan, 20% cheaper in China, 10% cheaper in Canada. So whatever metric you look at, the US dollar is vastly overvalued. Second part of the argument is that we've had enormous capital flows going into the US dollar, and the weird thing we've had is we've had a deficit, trade deficit, current account deficit keeps getting bigger and bigger and bigger.
And what textbooks say, well, what should happen then is the currency weakens so that things realign. We get equilibrium, you import less, you export more. But what's happened this time is even as the trade deficit gets bigger and bigger and bigger, the currency gets stronger and stronger and stronger. And the reason for that, according to the White House in particular, is Stephen Miran, who's Governor of the Fed and chair of the Council of Economic Advisors, is because of inflows from Asia, particular inflows from the People's Bank of China buying treasuries, bidding up the value of U.S. dollar at the same time bidding down the value of their currency to subsidize their exports.
So, it's part of their industrial policy. So that's a key part of the argument. The third part of the argument is that the US dollar is vastly overgrown globally. The US population is 4% of the global GDP, it's 20% of the global. But when you look at financial metrics, it overall represents about 60%. If you look at FX (foreign exchange) reserves, global trade financing, all these different metrics.
So, it's punching way above its weight. You mentioned it's the anchor. I think it's way beyond the anchor. It has ended up with this preeminent position which made sense maybe in a world in which the US was the sole hegemon, ... the sole power. But with the rise of China, the US is sharing the spotlight, and the US dollar will still remain the primary global reserve currency for a decade, maybe two.
But its preeminence should be lower than it is today. It shouldn't be at 60%, maybe it should be at 40%, something like that.
Ingrid
And there was a fourth piece, that piece. I think you were right.
Kevin
Yeah. And so, the fourth part of the argument is the response from the White House. Their perspective is you have a structural problem. And often when people look at the dollar, they focus on cyclical issues. They say, well, maybe the Fed is going to cut by more than the Bank of Canada. So, in the short term, it's interest rate differentials that drive currencies.
So that should mean a weaker dollar. But this is a structural problem. So, you're going to really need structural solutions to it. And the market clearly isn't doing it. And if the US just has a “laissez-faire” attitude, not really any type of industrial policy, then we get a continuation of what we've had for the last couple of decades.
Deficits keep getting worse and worse and the dollar keeps getting stronger. So, we need a solution which is in the Mar a Lago Accord. So, it's sort of a cheeky play on the Plaza Accord from 1985 would involve ethics intervention, for example, to get dollar China at much lower levels. It could include capital flow restriction. So, to stop the People's Bank from buying so many treasuries and other securities driving the currency up, it could involve yield curve control.
So, intervening in markets to keep interest rates relatively low, to discourage these types of capital flows, there's a lot of different elements the White House is talking about right now. The administration is very focused on the real economy, the goods economy. So, with tariffs trying to open markets for U.S. exports, trying to encourage companies to invest in America, these sorts of things, the next step is really focused on the financial economy, the U.S. dollar and interest rates.
And right now, this is speculative. The White House hasn't decided what they're going to do, and we know that they're going to move in baby steps and they're going to give lots of forward guidance because they're aware this could cause a lot of market volatility. But this is the direction the White House is going to move in and has to move in, given that they're their primary economic objective is rebalancing the economy.
Kevin
And that can't happen with current market conditions over the dollar so overvalued.
Ingrid
The next couple of questions we're going to ask you pertain to the impact on investors. Now you're U.S.-based. So the first question I want to ask is, with your U.S. hat on, when you're sitting in the U.S., you're not worried about the U.S. dollar relative to - from an investors perspective, because, you know, U.S. retirees, their obligation is in U.S. dollars.
So, when we look at it in the U.S. market, talk a little bit about what it would mean in sectors. What does a U.S. dollar ... how does that play out intra market? And then we're going to come back and talk about a Canadian investor perspective.
Kevin
So, a weaker U.S. dollar broadly means weaker global financial conditions, easier global financial conditions, so more money. And that's because a lot of foreign countries, foreign companies issue debt, U.S. dollar based hard currency-based debt. And so, if the dollar weakens, it's easier for them to pay back that debt. So easier global financial conditions and that typically benefits cyclicals.
So, for example, if you look over the last 40 years of the relationship between the U.S. dollar and emerging markets, that's 90% correlated over the last 40 years. So, a weaker dollar should be good news for EMs (Emerging Markets) relative to developed markets. In terms of sectors, it typically benefits sectors like materials and industrials are very cyclical sectors that would get the best benefit.
And often these are sectors that issue a lot of debt as well. So overall, it's very good for EMs. Also, Europe and a lot of Europe are quite cyclical. And then within a particular market, the S&P in the U.S. or TSX in Canada, sectors like industrials and materials, the heavy cyclical sectors.
Ingrid
Right. So as a U.S. portfolio manager, that might be how they're thinking about their allocation within their U.S. equity, as well as an asset allocation decision developed versus emerging markets. As Canadian based investors, many of us who have a meaningful portion of our portfolio in equities and a significant portion of those in the U.S. dollar, however ... “when I retire, my liability is Canadian dollars.”
Yeah, how do we think about that?
Kevin
Yes. So, if you're a Canadian based investor and you have some exposure to U.S. dollar assets, fixed income, equities or whatever it is you're taking on currency risk. And over the last decade, you've been rewarded for taking that currency risk because the U.S. dollar has appreciated. So, you've been incentivized not to hedge and not to think about it. Going forward,
We think the currency risks are much more two-sided than they've been in the last decade. In all probability, I think the U.S. dollar is going to weaken quite significantly against the CAD and other currencies. So Canadian investors should be thinking about hedging if they haven't been hedging, maybe to hedge 10% or 20% of their U.S. dollar exposure to get used to it.
What type of instruments to use, how to think about it. But stepping out, the right answer is definitely not a 0% hedge. The right answer is probably not 100% hedge because you can end up being over-hedged in these situations. But we're trying to encourage people to do is to think about it again, moving in baby steps, moving out the curve of that.
Ingrid
And I think it's like asset allocation as you think about, you know, when do you when are you in accumulation mode? When do you just let your portfolio do it? It's doing and then you can think in a reversion to mean. But I think by myself I'm a free retiree and not far off - days, weeks, months. I actually care meaningfully about what happens in my portfolio, but there's a cost associated with hedging, right?
So, there's a little bit of a drag. But when you're starting to say 10, 15, 20%, that could significantly wash away any upside I might be getting in my U.S. equity returns. And I think that's really important for investors to think about or talk to their advisers.
Kevin
Oh, yeah. So, the current cost for a hedge would be about 160 basis points. Yeah, just given where the U.S. three year is versus the or three months versus the Canadian three month. But say, over the next year, we think the Fed is going to cut by four or five times each time, 25 basis points where the Bank of Canada will cut once or twice.
So that 160 basis points goes below 100 basis points. So, you'd be paying less than 1% to hedge to buy insurance against a potentially.
Ingrid
10-20% ...
Kevin
15, 20% move in the dollar. And we think that makes sense.
Ingrid
That makes a ton of sense. We were talking a little bit as we were preparing for this about the concept of Fed independence. And you were talking moment ago about what the White House might do. And as you said that I thought, you know, the line is starting to blur here, talking about that concept. And what have investors been asking you about?
What have you been saying about the sort of shift in the way that the line between ...
Kevin
So, stepping back a little bit. So, Trump is bringing a whole “government approach” to rebalancing, and so he wants all of the government behind him and working in this direction. So, there's corporate statism has become a real thing in the U.S. where the government is taking stakes in companies like Intel, like MP Materials in Aerospace. Recently it's how to deal with some of the pharmaceutical companies Pfizer, AstraZeneca, to encourage them to locate production in the U.S. rather than abroad.
And active pharmaceutical ingredients are one of the real chokepoints and vulnerabilities in this economy. Certainly, for semis, it's true for shipbuilding, it's true for a host of sectors. This is going on. So, you have a government that's believing less and less in the ability of markets to solve these problems, because we've let markets do everything. We haven't had really industrial policy since Reagan.
And we've had a lot of problems built up as a result. And so, this thinking is also being applied to the Fed now. So, the idea with the Fed is you should have a non-partizan impartial group of bureaucrats who have special knowledge and expertise, for example, in setting interest rates. And they should be doing this. But we have two problems with that.
One is we have mission creep. So, they're not just doing interest rates, they're doing bank supervision, they're doing central bank credit lines, they're intervening when there's a financial crisis, in (the) COVID (pandemic) global financial crisis and so on. And you could certainly make a strong argument that these sorts of activities should be part of the executive branch. The White House, rather than an independent agency.
The second problem with the argument is the Fed is actually quite partizan. You know, the Supreme Court is supposed to be independent as well, but we have three Democrats, three moderate Republicans and three conservative Republicans, and it's not. In similar with the Fed. If you look at the chair previous to Powell, Janet Yellen, a great economist, but she's Partizan, she's a Democrat and she was treasury secretary under Biden.
And there are certainly people in the Fed governors now who are quite partizan people, and there are regional bank presidents who are quite partizan. (Austan) Goolsbee at the Chicago Fed, for example, and Lisa Cook as a governor has, she's a good economist but has come under a lot of pressure. So, this notion of Fed independence is getting attacked from lots of different directions.
So, there's seven governors in the Fed currently. Three of those are Republican and in line with Trump agenda. So, there will be a fourth either in January when the Supreme Court hears the case about the ability to fire Lisa Cook or in May when Powell's term as chair is over. But pretty soon a majority of Fed governors will be Trump appointees.
And then we should expect a lot more exertion of authority over the Fed coming from the Fed. And we can focus on interest rates because that's sort of what we know about. But that's sort of the least interesting part of it.
Ingrid
Okay.
Kevin
So, bank supervision is much more important. And if you followed the Jimmy Kimmel episode recently, the pressure put on Disney, for example. So, it's reasonable to expect that Trump aligned bank supervisors might talk to Bank to say, well, why are you lending to these particular companies? Because they're not really friendly with our agenda. And you're not being, you know, the terms you're giving to our allies aren't really that great.
And I think if we were talking a year or two ago, that might sound sort of preposterous. So that would happen. I think today it sounds pretty reasonable. Similar with swap lines, this could become partizan. What is your relationship with other countries and then your ability to use the Fed's balance sheet in an emergency could become quite partizan.
So, I think we have to be preparing ourselves for an instance in which (A) we have corporate statism. The government is much more involved in the corporate sector in many sectors.
Ingrid
And the Fed is part of this. And as a government investing balance sheet dollars and these corporations? Like almost ... they’re making, they're putting money into work. Or there ... is that actually then to the benefit of the balance sheet of your I mean like I'm trying to think though I'm trying to think through what that actually looks like because I'm understanding this in the theory and because I've never seen anything like this before in 40 years in this industry.
I'm still having a little bit of trouble wrapping my mind around it. Yeah, it's literally balance sheet dollars that are going to take up stake in these companies.
Kevin
So, there's different balance sheets within the U.S. government. You know, the Treasury has a balance sheet and that's being used, for example with Argentina Now in the Fed has the biggest balance sheet in the world. But you know, whichever balance sheet is going to be used, it'll be used for investments in companies like Intel, in MP materials and rare earths.
Yeah, in a host of sectors that are important to the Trump administration for reshoring, rebalancing, reducing chokepoints and vulnerabilities, we should be expecting a whole of government approach. Much more cooperation, statism and the Fed, I think, will be less independent and will be part of this effort.
Ingrid
And almost a tool to the government's whim.
Kevin
Yeah, well, the government's policy.
Policy, yes. Okay, we'll use policy. Before I take you to the lightning Round, we've talked about rare earth a little bit in here. We're recording this podcast in the middle of October. A lot might happen between now and the time that that we go live.
Kevin
Yes.
Ingrid
We've heard recent days, you know, this the noise again around tariffs on China. Can you talk a little bit about that for our listeners? Because again, by the time this plays out, I think it's pretty ... it's a compelling theme and it's interesting.
Kevin
So in in early October, China tightened up the export controls they have on rare earth, so if you want to buy rare earths or any type of product has rare earths in them, you need to get license and approval from China to do that. And they've been saying that their target really is - they don't want rare earths used for defense or military purposes, and also, they don't want them used for leading edge semiconductors because China's behind in these areas.
But it's caused a lot of concern. In the 1980s, the U.S. was the leader globally in the production and refinement of rare earths. Like so many industries, they've given up that lead to China. So, China currently leads ... currently mines 70% of the world's rare earths and refines over 90% of rare earths. So, in and in terms of the products that go into magnets, electric motors and so forth, and downstream of rare earths, it goes into so many different things.
If you're building F-35's tracking systems, drones, robots, anything with a motor, electric motor or magnet at it, it's going to have rare earths. It's a big part of the downstream supply chain. And so, the US needs to reshore that. There's only one company currently in the United States, “MP Materials”, (Mountain Pass) they mine in the Mojave Desert ... Mountain Pass, Mojave Desert in California, then they refine in Texas.
So, the US government has taken a stake in that company, but they need a lot more capacity. They can allocate capital to it; they can build the Capex for it. It's not clear that they have the people needed to do the mining and do the refinement, but this also offers an opportunity for Canada, as Canada has a lot of rare earths and has capabilities.
So, it's one of those Win-Win areas, and I think the Canadian government needs to look for more of these win areas with the Trump administration.
Ingrid
Probably part of the Secret 51st state agenda in some ways. It makes us a little bit more attractive. Yeah. We're going to take you in a moment to the lightning Round. But I think for our listeners, we've talked a lot about it here. But again, the central theme here is this potential for a very significant and persistent shift weaker in the US dollar, which will have a meaningful impact on Canadian investor portfolios.
And again, the call to action here is to think about hedging strategies, talk to your advisor and understand what not taking a decision around that could potentially mean. So, with that, I want to wrap up with the “Rapid-fire” session. I'm going to throw three ideas and themes at you. And as my teacher in high school used to say ... “Expand!” Is gold a “BUY”? I think we're $4200 U.S. today.
How much further?
Kevin
So, the golds had a great run, more than 50% this year after a great run. Also in 2024, the key driver appears to be foreign reserve banks. So, China, India and other reserve banks, including Russia, are moving money maybe from treasuries into gold. Gold has been a currency for over 3000 years. Different governments cannot manipulate it. It can't be part of their industrial policy.
So, there's a lot of reason to believe that this diversification of foreign central banks and the reserves and other economic factors will want to be increasing their allocation of gold. So, it looks like a secular story that's got a nice tailwind that's going to run for quite a while. There might be pullbacks in the story and that happens with every market.
Kevin
But it looks like this is a secular bull story.
Ingrid
I didn't have this as a thought here, but you know, as we're talking about a weaker U.S. dollar and we often talk about gold as a hedge against a weaker U.S. dollar or a store of value. We haven't talked a little about crypto or stablecoin or where does that play in this narrative?
Yeah, so if you're looking at fiat currencies, the U.S. dollar and others, there's lots of problems. And we've really only had fiat currencies, not gold based since the Nixon shock in 1971. So, we've had this experiment since 1971, um, say for 54 years, and they're starting to show signs of cracks. And this experiment. And so, people are looking for alternatives to fiat currency.
So, gold and silver are interesting, but it's more of a trade than investment, golden investment and then crypto certainly interesting. There's a lot of grift in crypto space, but Bitcoin and other types of crypto do look interesting. It's certainly Stablecoins are going to have enormous growth in all likelihood going forward. And the Trump administration has extreme and extremely favorable regulatory framework for crypto.
Kevin
So, we're going to be seeing lots of experiments. Some things will work, some things won't work, but it's going to be very interesting over the next few years.
Ingrid
Hard to value, hard to predict, but interesting to watch. Okay. Number two on my rapid-fire - yields, are they going to spike?
Kevin
So, you would think that if part of the story of reducing the value of the US dollar is to impede capital flows, you think that means higher interest rates? But in 1971, interest rates went down, in 1985 interest rates went down, and so far, this year interest rates have gone down. Additionally, I think when the Trump administration has more control over the Fed's balance sheet, we will see yield curve control.
So active policy by the government to prevent, say, the 10 to 30 parts of the yield curve from moving up. Yeah. So, my feeling is that this will not result in higher interest rates though you can make the argument why it should, but the historical evidence says it hasn't happened. And I think the Trump administration has good reasons to try to keep interest rates from going up further.
Ingrid
Okay. We've talked an awful lot about the “what?” of the US dollar, but I'm sure people are going: “when?” So how fast could we see this move in the U.S. dollar?
Kevin
So, there's the cyclical part of the story. And so that's driven by short term interest rates. And so, in all likelihood, the Fed cuts by more than the Bank of Canada. And so that's sort of the....
Ingrid
Of the U.S. (Federal Reserve)
Kevin
... a 12-month cyclical catalyst. But it is a secular story. It's overvalued valuation that's been built up for over a decade and these cycles stories unwind over long periods. It's not one quarter two quarters. I think the remainder of the Trump second term. So more than three years, then 10 or 15% and probably has a bit more than that.
And typically, in these situations the currency undershoots. But I would say we have a cyclical component that's maybe one year, but it's more of a 3-to-5-year story.
Ingrid
And 3 to 5 years. We could see 20% weaker on the US dollar. Last question that I wanted to insert here and we didn't talk about that. You're a member of the Wealth Asset Allocation Committee. How is the “WAAC” thinking about this move in the currency?
Kevin
So the asset allocation committee has an underweight recommendation on the US dollar and is also looking for opportunities for investors to you know, when you look at the U.S. equity market, for example, the tech sector is unique, it's exceptional, has fantastic earnings growth, great return invested capital, some other sectors in the U.S., trade on high valuation premiums relative to their counterparts in the UK, Europe, Japan and China, but don't really have fundamentals to justified.
Kevin
So, I think diversifying, looking beyond the United States for global champions and sectors outside of tech I think makes a lot of sense.
Ingrid
Okay, this conversation we've tried to cover a lot in 20-25 minutes. It's been fascinating. Again, this discussion should give advisors, investors food for thought consideration around how to think about how the U.S. dollar and exposure in your portfolios may be impacted. Also, I invite you to read Kevin Hebner's recent article. You can find it on our website or reach out to your advisor with an email.
Thanks so much and have a great day.
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