An evolving role for the dollar and the Fed

By Atul Bhatia, CFA

It’s easy to let preconceived notions slip into portfolio construction and investment analysis. Background ideas on policymaking and the relative importance of different indicators can become baked into thinking, without being directly reviewed.

This is generally a no-harm, no-foul situation: these conditions change slowly and infrequently, although when they do change, the impact can be great. Prior to Silicon Valley Bank’s failure in March 2023, for instance, we think few investors considered the impact of unrecognized marked-to-market bond losses on depositor behaviour. It was a reasonable assumption, until it wasn’t. The result was a sharp disruption across regional banks.

Looking ahead, we see two areas where prior assumptions, we believe, may no longer hold true. One is on the dollar’s ubiquity in trade and savings, and the second is the primacy of monetary policy in creating investment conditions.

Dollars, dollars everywhere

When it comes to currency allocation, the dollar usually wins by default. Eurozone sovereign debt was issued by individual countries, many of which came with high perceived credit risk. This left investors with too few investment vehicles for euro holdings. Ditto Japan, where extremely large government debt was combined with anemic interest rates, a double whammy for yen holders. Other currency options were just too small or too regional to rival the greenback. The result was no acceptable alternative for the U.S. dollar.

But it’s important to remember what’s deemed acceptable changes with circumstances. A rowboat is not a viable means of transport in the North Atlantic, but for passengers on the Titanic, that calculus quickly changed. While the U.S. is by no means a sinking ship, there are two factors that we believe weigh against the dollar continuing to be viewed as the only game in town for savers:

• Broader global investment opportunities: We believe European military spending is likely to increase, and eurozone-wide debt would be a reasonable funding mechanism, giving investors the type of saving vehicle they have been seeking. At the same time, rising yields in Japan have put the yen back on the table.
• Higher perceived cost to holding U.S. dollars: Owning dollars and Treasuries makes someone subject to U.S. law and policy. When that power was wielded for largely political goals, traditional allies likely felt there was little risk created by entering that ecosystem. But if the power is wielded – by the current administration or a future one – for strictly commercial ends, then every nation is potentially subject to pressure.

Our argument is not that the dollar is doomed to free fall. The Americas are leaders in energy and food production and protected by two oceans – a nice place on the planet during times of rising tension.

Instead, our contention is that changing conditions make it increasingly difficult to consider a fully dollarized portfolio as sufficiently diversified, and that investors need to build exposure to a broader set of developed market currencies.

Fiscal over Fed

For almost 30 years leading up to the global financial crisis (GFC), it was the age of monetary policy in the United States. There were exceptions, such as the savings and loan crisis, but in general, monetary policy drove the bus when responding to the business cycle.

This was less by economic design than political reality. Outside of the automatic stabilizers of tax receipts and unemployment benefits, fiscal policy moves meant legislation, and it was tough and slow to shepherd a bill through the various subcommittees and votes required to make law. Monetary policy was fast and effective, so it was the response mechanism of choice.

Since the GFC, and even more since the COVID-19 pandemic, we see both sides of that framework coming under pressure.

On the fiscal side, we’ve seen the unleashing of the federal balance sheet. The scale of the GFC response was massive, and, we believe, it taught Washington that pushing the deficit higher had few costs and brought immediate gratification: higher growth, rising asset prices and happy constituents. The fact that this painless deficit expansion was only possible because of a massive private sector contraction was conveniently forgotten. Since then, the federal budget deficit has shifted from its prior baseline of about two percent of GDP to approximately six percent of GDP, an unsustainable pace of debt accumulation, in our view.

We’ve also seen a weakening of the procedural hurdles that often kept fiscal policy on the sidelines. As the current administration has shown, significant actions can be taken via executive order or through broad interpretation of existing legal authority. While not all of the moves pass court muster, we think non-legislative activity is likely to continue and increase.

Monetary policymaking has not undergone the same degree of evolution, but the link between the Federal Reserve’s action and the broader economy has weakened, in our view. The disconnect comes because the Fed operates by manipulating overnight interest rates, but the economic heavy lifting comes from changes in longer-term borrowing rates, particularly the 10-year rate. That maturity has significant influence on mortgage rates, corporate borrowing costs and the valuation of long-dated investments.

Historically, Fed moves on the overnight rate were transmitted with varying degrees of success to longer-term interest rates. The current cycle, however, stands out for the significant disconnect. While the Fed has cut rates by 1.75 percent since Sept. 2024, 10-year Treasury yields are roughly 0.6 percent higher in that period.

This type of deviation is not unprecedented. In the early 2000s, for instance, the 10-year was essentially unchanged despite rising Fed policy rates, but the current episode is the most notable example of 10-year yields rising despite a Fed cutting cycle.

While it’s possible that the current episode is an outlier, we think there are reasons to believe that rate-cut cycles may not be able to stimulate as well as they have in the past. To begin with, the recent bout of inflation has weakened the Fed’s credibility in terms of price stability, and that’s likely to create a lingering risk premium in longer yields.

More importantly, we believe the trend in fiscal policy is working against the monetary lever. Significant federal budget deficits on top of extremely large debt burdens make it more difficult for markets to digest new Treasury issuance, and policy uncertainty tends to raise the cost of borrowing.

Shifting sands

Our view is that the evolving role for the dollar and the challenges facing monetary policymakers make this a good moment for investors to reevaluate the unstated assumptions that many of us bring to portfolio building. In particular, we think investors need to appreciate how federal government actions can influence Treasury demand, and how currency diversification can play a risk-mitigating role in constructing a portfolio.

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