Whither US inflation, whither the Dollar?

Peter Warburton and Tom Traill - 18 August 2020

About 4 years ago we stumbled across an intriguing inverse correlation between the real return on US deposits to an overseas investor and the current rate of US inflation, as measured by the CPI. This correlation started to appear around 2006-07 and has persisted. As a rule of thumb, for every 1 percentage point that inflation falls short of 2 per cent, a foreign investor could expect 5 percentage points of annual real return. Our hypothesis of a near-term spike in US inflation has correspondingly adverse implications for returns to Dollar deposits. We contend that US inflation has embarked on a wild ride that overseas investors in US Dollar assets will find nauseating.

The relationship is shown in figure 1. Our first thought was that the relationship was a tautology due to the appearance of CPI inflation in both series. But this is not the case. Inflation does contribute to the variation in the real return on US deposits (defined in terms of the Federal funds rate) but the dominating variable is changes in the external value of the US Dollar (as measured by the JP Morgan nominal effective exchange rate index). Moreover, if there were an element of tautology, then the correlation would be present in all time periods, which is not the case: it appears around 2006-07.

We have examined the same relationship for the Euro (figure 2), for Sterling, and the Japanese Yen. There is no comparable correlation for other currencies, except over short intervals. Typically, CPI inflation follows currency change with a lag of around a year, which describes a different mechanism altogether. The US Dollar relationship is echoed for the RMB between 2007 and 2014, when the RMB was effectively pegged to the US Dollar. A simple linear regression on the US data since 2007, yields: Annual real return on US$ deposit (%) = 9.86% - 4.69* CPI inflation (%). In other words, 2 per cent inflation is associated with zero real return. The identical regression for the Euro yields: Annual real return on Euro deposit (%) = 1.46% - 0.01 CPI inflation (%).

The best rationalisation of the evident correlation in figure 1 is the prevalence of the international search for yield. The lower the outturn for US inflation, the better the outlook for capital appreciation in US securities – government and corporate bonds and equities – and the stronger the inflow of foreign capital to the US. The attractiveness of the US as a destination for foreign portfolio capital has been predicated on a benign inflation performance and a docile Federal Reserve. We contend that US inflation has embarked on a wild ride that overseas investors in US Dollar assets will find nauseating, notwithstanding the acquiescence of the Fed.

It is interesting to note that even the upward drift of US inflation from near-zero in early 2016 to almost 3 per cent in mid-2018 was associated with a material setback for the US Dollar (from 126 to 113) and hence the real return to a foreigner of a Dollar deposit. The ‘safe haven’ characterisation of the US Dollar may require heavy revision in this light: ‘least dirty shirt’ may be closer to the mark. The flood of portfolio capital towards the US since 2018 may reverse more violently than many expect if inflation takes off as we expect.

Figure 1

Data source: Thomson Reuters Datastream

Figure 2

Data source: Thomson Reuters Datastream

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