The global financial, monetary and economic landscape is once again shifting and the changes that are already underway are bound to have a significant impact on investment strategies. After much speculation and anticipation, the Federal Reserve recently announced its decision to cut interest rates by 50 basis points, very likely signaling a return to a more dovish policy direction.

Monetary U-turn

Even though this decision was largely expected for months, the market hadn’t fully priced it in and the reaction was noticeably positive. The prospect of abandoning the “higher for longer” mantra (which only lasted 18 months) and getting back to cheap borrowing and easing understandably and predictably received a warm welcome.

However, the timing of this policy U-turn was interesting. In Chairman Powell’s own words, there is “no risk of a recession or downturn,” while he sees a “solid economy” and a “strong job market.” Indeed, the US economy might be expanding by less than 2%, which is not exactly ideal, but still, it offers no reason to panic and there are no immediate threats of a crisis on the horizon.

Apart from the threat of inflation, of course. It still presents an ongoing problem, which the return to easing is only going to exacerbate. CPI figures have come down from the highs of the past years, but still remain above the Fed’s own target, which to many suggests that it is too early to start another rate-cutting cycle.

In the shorter term, we wouldn’t be surprised to see some more disinflation or even deflation. However, what is even likelier is that eventually, we will see another wave of “whatever it takes” easing policies to save the economy as it keeps deteriorating and to support an increasingly frail labor market. That’s when a second wave of inflation will be triggered, together with little to no real economic growth, resulting in what is commonly described as “stagflation.” It is important to note here that this second wave of consumer price increases doesn’t even need to be that severe in order to be destructive again. The first wave of inflation from May 2020 to September 2022, which was accompanied by an increase in the core CPI from 0.3% yoy to 6.7% yoy, has already caused lasting damage, as prices have risen to much higher levels, permanently reducing purchasing power. Similarly, the Fed’s anti-inflationary tightening cycle, with its aggressive interest rate hikes, has led to higher borrowing costs for consumers and businesses, with all the negative consequences that entails.

Therefore, even without a hyperinflation worst-case scenario, the average household will still suffer significantly even under more “moderate” inflation conditions. Let us not forget that already in August the Federal Reserve Bank of New York revealed that Americans owed a record $1.14 trillion on their credit cards, while an investigation by the Wall Street Journal in late September revealed that the US is “set to break a new record number of homeless people with more than half a million people living on the street this year."

What’s more, as economist and fund manager Daniel Lacalle recently highlighted: “Lowering rates will have a limited impact on the real economy because a 15-year effective mortgage rate remains at 5.6%, and financial conditions will not ease significantly. Furthermore, it is difficult to believe that families and businesses will start demanding more credit with record levels of credit card debt."

So if the Federal Reserve doesn’t perceive the economy as being in dire straits, and if inflation is still a threat, why did the central bank decide to cut interest rates, and by 50 basis points to boot? Well, there is another glaring explanation as to why the need to ease reemerged. The “elephant in the room" is the crippling $35.3 trillion government debt and the unsustainable interest payments that have already cost over $1 trillion, according to the Treasury Department. It is clear that sticking to higher rates put the US government under immense pressure, and even though the nation’s central bank is supposed to be totally independent, its officials cannot possibly be unaware of it or uninfluenced by it.

Figure 2: US dollar index (DXY)

As we already outlined in 2020 in great detail in our BFI Special Report, the only ways to tackle debt (especially of this magnitude) are economic growth, default, austerity, inflation, and financial repression. Economic growth cannot be relied upon to manifest itself under present conditions, default is simply unthinkable for any developed nation, and austerity is totally politically untenable. Inflation through easing and money printing and financial repression are the only options left open to governments.

Grim outlook for the USD

The greenback’s value can be tracked through two key metrics: the DXY index and against gold. The DXY (US dollar index) is a weighted average of the dollar’s exchange rate against a basket of major foreign currencies, like the euro, the yen, and the pound. Gold is also used a comparative measure, as it serves as a long-standing safe-haven asset and a hedge against currency depreciation. Especially when viewed in gold terms, as seen in the chart below , the currency’s weakness is laid bare.

We are at an important turning point which is somewhat comparable to previous dollar cycles with peaks in the mid-80s and 2001/2002. When interest rates start to fall, it comes with far-reaching consequences and large swings in the value of the currency.

Of course, it’s not just the Fed’s U-turn that supports this case; it would be too simplistic to think that this alone could cause the USD to resume its long-term downtrend. The dollar’s position in the world economy is not as certain as it once was. The de-dollarization trend that we have previously talked about in our reports, is also an important theme. Of course, it is not a shift that will happen overnight, and the USD will not be dethroned as the world reserve currency from one day to the next. However, we are already seeing significant moves by challenger global powers, especially China, to reduce their reliance on the USD.

Figure 3: Gold at record highs

The weaponization of the American currency against Russia since the start of the Ukraine war has certainty made it clear to many nations, especially emerging ones, that it is strategically unwise to be entirely dependent on the dollar. Russia’s energy deals with China, have paved the way for the yuan to reach a record high in international transactions, as the Financial Times (FT) reported recently. The BRICS+ bloc is still growing, with NATO-member Turkey announcing it submitted a request to join last month and Malaysia and Thailand also expressing interest. This indicates a slow, but decisive move away from a US-centric world, to more multipolar global order, which would most certainly have a negative impact on the dominance of the USD.

However, there is another important development that suggests a historic shift is underway. Again, it is important to understand that all markets are interconnected; however, the price drivers behind commodities and emerging markets are probably more linked to another important event we had very recently. On September 23, China announced a package of new support measures, including a cut in the reserve requirement ratio. It is not only these measures themselves that are surprising, but also the way they were announced and communicated to the market. China is clearly becoming more determined to actively turn its slumping economy around.

We must keep in mind that the Chinese equity market has been one of the worst performing markets in recent years. And when China is in trouble, this normally means that emerging markets in general are not doing all that well either. We are of the opinion that the significance of the current global turning point in interest rates should not be underestimated. While the largest economy in the world is at the start of a rate-cutting cycle, China’s economy is entering its next chapter, with increasing support from the government and the central bank. The recent spike in Chinese stock prices certainly suggests there is a bigger story brewing in China, even if it cools down, which could have important ramifications for other markets too.

Implications for investors

At this point, we’d like to make it clear that we don’t anticipate the dollar’s value to decline in a straight line.  To the contrary, it is not unlikely at all that we could witness some stability in the near term, due to the relative strength of the US economy. However, this strength doesn’t appear to have the fundamental basis needed to last much longer. This is why it is an excellent time for investors to benefit from the current, still higher USD levels and to diversify.

One way to do so, would be through relatively “strong” currencies, like the Swiss Franc. Also, commodity currencies like the Canadian dollar, the Australian dollar, or the Norwegian Krona have the potential to be strong currencies, as we expect their underlying commodities, due to many reasons, to perform well over the next few years. Alternatively, investors can take advantage of potentially upcoming opportunities in emerging markets with their own currencies. Last but not least, another, more robust solution would be to invest in hard assets that cannot be created out of thin air, like gold, silver, energy, uranium, base metals, and certain real estate.

To access the full BFI Infinity InSights and read more about the second article in it, click here.

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