Make the dollar weak again!

Read the market analysis and fund positioning

The dollar is our currency, but it’s your problem. With these legendary words in 1971, John Connally, US Secretary of the Treasury under President Nixon, summed up what is still true today: the world dances to the tune of the greenback. Reason enough to take a closer look at the US dollar, its importance, its drivers and the implications for investors.

King Dollar: Why the world depends on the greenback

The US dollar is the world's most important transaction, investment and reserve currency - a kind of lubricant for the global economy. As such, the greenback dominates the international financial market. In the first quarter of 2024, central banks worldwide held around 59 per cent of their currency reserves in dollars. To illustrate the importance, almost half of all transfers (about 47%) and almost all foreign exchange transactions (88%) are in dollars. The dominance of the dollar is particularly evident in the oil business: some 80-85% of all oil purchases worldwide are paid for in US dollars. The dollar is to the financial world what English is to the financial world - a language that is understood and accepted everywhere.

This dominance is a thorn in the side of other economic blocs, that want to dethrone the dollar. The BRICS countries (Brazil, Russia, India, China and South Africa) dream of a world without dollar dominance. Their goal: to break dependence on the dollar. But so far, all attempts at ‘Dedollarisation’ have failed. The US currency remains unchallenged. Old habits die hard. So the greenback will remain firmly in the saddle of the global economy for the foreseeable future.

What drives the US dollar?

Three factors drive the exchange rate: interest rates, economic growth and trustworthiness.

These are usually multi-dimensional, but one often dominates. In addition to the interest rate differential (often a function of inflation), the growth differential and the safe-haven status of the currency are also included. At least in theory, the adjustment of exchange rates should mean that goods and services in a basket of commodities can be bought at the same price in two different currencies (purchasing power parity).

So, if higher inflation in the US leads to higher interest rates than in the eurozone, people will invest their money in US dollars. The result: the dollar rises! The interest rate differential is analogous to the growth differential: is the US economy booming more than others? The dollar rises! Equally important is the safe-haven function: is there a crisis in the world? Investors flee to the dollar! In times of crisis, investors seek protection and safety for their money. They invest in currencies that are perceived to be particularly crisis-resistant due to political and institutional stability or confidence in the central bank. In the recent past, the euro crisis of 2012/2013 is a good example of the US dollar as a safe-haven. At the time, investors were literally driven by fear.

‘Dollar smile’: Strong US dollar due to fear and greed

The following chart provides a simplified illustration of the impact of the growth differential and the perception of the US dollar as a safe-haven currency on the strength of the greenback: the 'dollar smile' chart shows economic expectations on the X-axis and the strength of the US dollar on the Y-axis. At first glance, it is clear that the US dollar tends to strengthen when the environment is very bad ('fear') and when the environment is very good ('greed'). Unless the US has a significant growth advantage, the US dollar tends to weaken.

The US dollar in descent

So where are we today? Growth in Europe is below average but catching up. By contrast, the US economy is cooling down. The growth differential is therefore narrowing, and the interest rate differential is also moving against the US dollar. The fact that the Europeans are currently showing unity, including on military and fiscal policy, is weakening the safe-haven argument for the US dollar. These facts, combined with the moderate global growth we expect, create a "dollar smile" chart that does not justify a strong dollar. In addition, the new US administration appears to be deliberately working to weaken its own currency.

Donald Trump's dollar mission: Mar-a-Lago instead of Plaza

“Make the dollar weak again” - this could be the motto of Donald Trump's currency policy. The plan already has a name: the "Mar-a-Lago Accord", named after Trump's Florida estate. The historical model: Ronald Reagan successfully devalued the overvalued dollar exactly 40 years ago with the so called "Plaza Accord". The parallels are unmistakable - Trump wants to follow in the footsteps of his Republican predecessor. It is unclear whether the leading industrial nations will actually work together in this way. But the new US president is seeking to weaken his currency, not least in order to make his own products more competitive abroad.

Our conclusion is clear: we have fully hedged our dollar positions and expect a period of dollar weakness. This is very much to President Trump's taste, for whom a weak dollar is a beautiful dollar!