Secular Stagnation or not, the US Dollar can maintain its upward trajectory…
In an era of low rates, low headline inflation and stubbornly disappointing real growth, focus has returned to the concept of “secular stagnation” first created by Alvin Hansen in 1938 to describe the Great Depression. So what is it? Is it a real threat and, as the issue increasingly appears to be a global one, can the US Dollar benefit?
What is it?
The concept revolves around the idea of perpetual low real growth and low real interest rates. At its very core is an excess of desired savings over desired investment. There are two ways for this to happen at a country level. Either through a trade surplus or via undesired investment (i.e. unwanted inventory accumulation). The former has to net off globally whilst the latter creates problems. As companies scale back investment, incomes fall. Via the paradox of thrift, individuals save even more, further depressing incomes and the cycle continues.
It is important to note that stagnation is not about potential supply but about global demand. That said, falling investment over time can and will drive potential output downward. This provides a very undesirable outcome where real growth remains low whilst inflation eventually picks up as potential output falls towards demand, unconventionally diminishing slack.
Monetary policy becomes ineffective in this scenario as the real interest rate which equates savings and investment falls well below zero. Although policymakers have shown a willingness to move towards negative rates, a liquidity trap limits its ability to affect saving rates.
Instead they must turn to increasing inflation expectations to reduce real rates via further quantitative easing (QE), fiscal policy and forward guidance. One of the key transmission mechanisms in this situation is a devaluation of the exchange rate, but this tool cannot solve everyone’s problems.
Does it exist?
So does secular stagnation exist and are we doomed to low growth and interest rates forever? Many arguments suggest this may be the case. Demographics, slowing emerging market growth, foreign reserve accumulation, slowing productivity and safe haven demand can continue to depress the equilibrium real rate of interest.
That said, it may be hard to see a way out after a near decade of low rates but future improvements in technology only seem realistic after the fact and history has proved the process of creative destruction goes on.
We are now starting to see evidence of an escape in the US economy. As employment continues to increase, wage price pressures are starting to build. Retail sales showed a strong rebound in May, including some hefty revisions, indicating demand is not as subdued as first thought. Seasonality and productivity mis-measurements may indicate higher Q1 growth.
Thanks to a rebound in consumer demand, real growth is also picking up in Europe, UK and Japan. Japanese GDP was revised upwards to an impressive 3.9% QoQ seasonally adjusted annual rate (saar) recently with private consumption contributing 0.9pp whilst UK consumption grew 0.5% QoQ. Although unemployment remains high in the EU, a recent pick up in core inflation has helped dispel fears of a deflationary spiral. The key message here is that the absence of inflation may not be due to lackluster demand but because “potential” output has improved more than expected over the last decade. Low inflation may be a sign of a decade worth of increasing slack. If this is the case, the US Federal Reserve (Fed) must stay ahead of the curve in anticipating future inflation.
How to Position
Secular stagnation or not, the US Dollar can still rise.
If you do not believe in secular stagnation, real growth will pick up followed by inflation as demand approaches its potential. Think about the economies that provide the most evidence of escaping the spiral of secular stagnation. The US and UK are starting to show signs of robust consumption and tentative evidence of rising wages. Signs of escape in the US reinforce expectations of the Fed beginning its hiking cycle soon, further building upon the divergent monetary policy theme in the G10 space.
On the other hand, in the gloomy outcome of secular stagnation, front end rates will remain suppressed, whilst the curves may steepen as potential output falls leading to inflationary pressures. From an FX perspective, central banks will continue to fight over their share of real global growth. The smallest, most open, economies will have the largest incentives to devalue their currencies. In this situation, rates will diverge not because of a US hiking cycle but due to the rest of the world easing further, still supporting the US Dollar.