US economy is in recovery

IMF President Georgieva said last week that, after a period of converging economic performance and monetary policy, there could be some divergence looming as the US outperforms many others. This sort of sentiment seems to be keeping the US dollar strong at the moment.

However, there are a number of points here which suggest that US dollar strength is not a given even if the US outperforms. The first, very obvious point, is that the US traditionally outperforms its peers. For instance, since EMU started the average US outperformance relative to the euro zone economy has been 0.7% points per year. The US is ahead of the UK over the same period by around 0.4% points and Japan by a whopping 1.5% points.

In fact, over the last 20 years, Japanese growth has only outperformed the US in 2 years (and it is only 7 for the euro zone and 11 for the UK). Hence, US outperformance is a given and, if it does continue in the future, as seems likely, it would only maintain the natural order of things. But the last 20 years have not seen the dollar appreciate continually. Compared to its level at the start of 1999, the dollar’s DXY index against other major currencies has risen by as much as 29% (in 2001) but has also fallen as much as 24% (in 2008) from this 1999 level.

In short, the US dollar has moved sideways despite the US’s growth advantage. If we look at Japan specifically, and go back a bit further, over the last 50 years we see that, despite an average US growth advantage of 0.6% per year, dollar/yen is around a half of the level it was at the start of 1973! Looking ahead, we see no reason why the US’s growth advantage should change. The inherent dynamism in the economy seems likely to persist thanks to key policy initiatives, like the inflation reduction act, technological leadership in areas such as artificial intelligence, the lack of any pressure for significant budget deficit reduction, and more. But will this strengthen the US dollar? Not necessarily if past performance is anything to go by.

This brings us on to the reasons why the US dollar does not perform better given its economic outperformance. Perhaps the simplest way to put this is to say that this outperformance exists because the US invests too much relative to the amount of savings in the economy. As a result, it has to suck in savings from abroad, which is the equivalent of the current account deficit. The accumulated deficit, the US’s net international investment position, is both large at around 63% of GDP and fast growing given that this proportion has doubled in the last decade.

As we see it, the need for the US to attract huge amounts of foreign capital almost necessitates that the country outperform others. This can either be in terms of economic growth, so that US equities are relatively strong and foreign direct investment in the US is attractive, or in terms of a relatively high level of US bond yields. If these inflows of foreign savings start to fall short of what’s required at prevailing exchange rates there is likely to be pressure on the dollar to fall even if the US economy is outperforming. Quite clearly the real danger arises if either US outperformance starts to become habitual underperformance, or overseas investors choose to direct fewer savings to the US for some reason that’s unrelated to relative economic/financial market performance. For instance, should FDI into the US be blocked by local or international political restrictions, as we have seen in the case of China, then this could negatively impact the US dollar even if the US continues to outperform.

“In the near-term we don’t doubt that US outperformance could continue to lift the US dollar, especially if it creates speculation of wider rate differentials but, over the long haul, relative economic performance is probably not as important as you might think when it comes to the US dollar”, said Mr. Steve Barrow, Head of Standard Bank G10 Strategy.