The decline in the US Dollar has been caused by three things 1) the explosion in ‘money’ and debt 2) the collapse in real yields underlying the Dollar and 3) a lack of control over the virus in the United States. This trifecta of threats to the US Dollar has accommodated the appreciation of the Euro to its current lofty valuations and raised a whole host of questions regarding the global economy. This brief looks at the first and arguably largest of the causes: the explosion of money and US Debt.
The graph below illustrates how much money is in the Eurozone and US economies respectively. The measure for those interested is called ‘M3’ and represents the amount of relatively and highly liquid money in a financial system at that point in time. Why does the supply of money in a system matter? Well, if money is the instrument through which we value our economies and assets within them then, even if the worth of an asset in our minds remains relatively stable, in monetary terms it will fall. An economy produces a finite amount of stuff whose value in turn is measured in money – another type of stuff. If the stock of that money is diluted then it is the money itself that loses value and not the asset. If this happens then one consequence is inflation, the other is devaluation of the currency as each unit of currency becomes worth slightly less. In the graph below you can see that money supply growth in the US has way out-paced its counterpart in the Eurozone. This has put downward pressure on the greenback and, unless the Fed curtails its current phase of monetary expansion the Dollar could continue to fall.
The effect of debasement within the US currency has facilitated a rotation out of the Dollar with the Euro finding itself as one of the main benefactors of the greenback’s decline. Last week, data showed that investors in futures markets were the most bullish they have ever been with respect to the European single currency. Net long, non-commercial positions surpassed 200,000 representing some $30bn in open ‘bets’ in favour of the Euro. The exposure to the Euro that has contributed to its 10% rise versus the US Dollar since May 2020 could now prove to be a ticking time bomb sitting beneath the Euro.
The Euro benefitted from the decline in the US Dollar thanks to positive sentiment surrounding the Eurozone following the approval of the European Recovery Fund and evidence of more competent containment of the virus outbreak. If headlines begin to sour in the Eurozone, particularly with respect to the infection rate and national lockdowns, a rapid ‘short-covering’ to eliminate this over exposure would put huge pressure on the value of the Euro. The healthy growth in the value of net long Euro positions has showed little sign of stopping in recent weeks. This will continue to accommodate the Euro’s appreciation but also add to the size of the bomb beneath the Euro.
Discussion and Analysis by Charles Porter