Don’t Fear the Dollar Bear: A Playbook for Bond Investors in 2021

Written by: Patrick Drum | Saturna Capital

In March 2020 the US dollar temporarily surged as a destination of relative safety amidst unprecedented global market chaos. Since then, much has changed, and the United States government has been particularly aggressive in introducing fiscal support during the pandemic against the backdrop of historically easy monetary policies from the Fed.

Despite recent strength, when looking at DXY (a measure of the strength of the USD) the question one must ask is if March 2020 represented “peak dollar strength” and for how long?

With the open question of the dollar’s potential peak in the rearview mirror, many other questions emerge: Could we be faced with a new and prolonged USD bear market? What are the implications for investors? And how can those with a mandate to hold fixed income or otherwise have moderate risk tolerance survive, and even thrive in conditions marked by rising inflation, declining purchasing power and rising interest rates

Evidence that a New Bear is Awakening

A new USD bear market is far from a certainty and has divided market observers. We have already seen a number of “head fakes” since the start of 2021, the most recent of which came last week after the Fed indicated a slightly more hawkish stance on interest rates. Despite such countertrends, DXY has steadily declined since its March 20 high, and the underlying trends that have driven it lower remain largely in place.

When examining the evidence for a potential new and significant USD bear, it helps to understand what drove the last significant decline in the USD, which began in 2001 and ran to the GFC in 2008. The decline of the US dollar from 2001 to 2008 has largely been attributed to an unprecedented US trade deficit, which grew in excess of 5.5% of GDP in 2006. These conditions drove a supply and demand imbalance in relation to the dollar.

Today we see the potential for another supply/demand imbalance.

Consider the following:

• US public debt as a percentage of gross domestic product (GDP), is at an all-time high of 135.6%.
• The CBO revised their April 2020 deficit projection of 4% to as much as 16%, the largest deficit since reaching nearly 30% during World War II, which some believe to be a dramatic understatement.
• The Fed vigorously embarked upon a massive asset purchase program in February 2020 that brought the federal deficit to a record $3.1 trillion during the 2020 fiscal year.  The Fed’s actions led to a 42% increase in its balance sheet that as of March 31, 2021 stood in excess of $7.6 trillion.

These points are in addition to the extremely loose fiscal and monetary policies that are still playing out in Washington as talks of an additional $1.9 trillion in infrastructure spending are underway.

For bond investors concerned with how the United States fiscal house looks now and what it could mean for their portfolios, let’s examine what worked during the last bear.

What Worked Last Time, 2001 - 2008 

Below we analyze risk-adjusted performance of major asset classes. As the last major USD bear coincided with the start of the GFC, we ran the numbers as of year-end 2007 and 2008 and let readers draw their own conclusions. 

2001–2007: Pre-Global Financial Crisis

 

Benchmark		Annualized return	Annualized standard deviation	Sharpe ratio
Cash	Bloomberg Barclays US Treasury Bills: 1-3  Months Index	2.93%	0.47%	NA
US Treasuries	Bloomberg Barclays US Treasury Index	5.54%	4.84%	0.57
Corporate Bonds, Investment Grade	Bloomberg Barclays US Corporate Bond Index	6.32%	4.72%	0.75
US High Yield Bonds	Bloomberg Barclays US Corporate High Yield Index	8.24%	7.85%	0.70
Emerging Markets Bonds	JP Morgan EMBI Global Core Index	12.28%	8.01%	1.19
Global Bonds (Non-US Dollar)	Bloomberg Barclays Global Aggregate	7.15%	5.47%	0.80
US Equities	S&P 500 Index	3.30%	13.28%	0.04
Growth Equities	Russell 1000 Growth Index	0.23%	16.43%	-0.16
Value Equities	Russell 1000 Value Index	5.30%	10.51%	0.24
Mid & Small Cap Equities	Russell 2500 Index	8.95%	15.90%	0.39
Global Equities (Developed World, Ex-US)	MSCI EAFE Index	7.12%	13.43%	0.32

 

2001–2008: Including Impacts of the Global Financial Crisis

 

Benchmark		Annualized return	Annualized standard deviation	Sharpe ratio
Cash	Bloomberg Barclays US Treasury Bills: 1-3  Months Index	2.78%	0.47%	NA
US Treasurys	Bloomberg Barclays US Treasury Index	6.53%	5.11%	0.73
Corporate Bonds, Investment Grade	Bloomberg Barclays US Corporate Bond Index	4.84%	6.47%	0.32
US High Yield Bonds	Bloomberg Barclays US Corporate High Yield Index	3.19%	10.96%	0.04
Emerging Markets Bonds	JP Morgan EMBI Global Core Index	8.96%	10.44%	0.59
Global Bonds (Non-US Dollar)	Bloomberg Barclays Global Aggregate	6.85%	6.09%	0.67
US Equities	S&P 500 Index	-2.88%	15.04%	-0.38
Growth Equities	Russell 1000 Growth Index	-5.69%	17.88%	-0.47
Value Equities	Russell 1000 Value Index	5.15%	10.29%	0.23
Mid & Small Cap Equities	Russell 2500 Index	1.79%	18.39%	-0.05
Global Equities (Developed World, Ex-US)	MSCI EAFE Index	-0.74%	16.14%	-0.22

Source: Bloomberg

As at the start of the last USD bear, bond investors today are potentially faced with the prospect of rising rates, higher levels of inflation and a weakening US dollar. However, the idea that losses for these investors are a foregone conclusion appears to be greatly overstated when reviewing asset class returns from 2001 – 2008.

Our detailed analysis of the last USD bear market revealed the benefits of diversifying bond investors’ exposure to non-USD international bonds and potentially emerging markets bonds, for those with longer-term outlooks who can cope with some volatility (equivalent to US HY bonds).

Adding international diversification to a bond portfolio may be an attractive option for investors unable or unwilling to add equity or hard asset risk to their portfolios at this time.

Among our findings:

1. Bond investors can experience positive returns in an environment with rising interest rates.
2. When reviewing the period of the last USD decline (2001 – 2008), the non-US dollar fixed income benchmarks (in particular, emerging markets and non-US dollar bonds) exhibited attractive risk-adjusted returns and favorable performance. This held true when both including 2008 and excluding it, meaning the sharp drop in equities and US high-yield bonds was not the main determining factor in these bonds’ attractive relative performance.
3. International non-US dollar bonds can give investors diversification and return benefits as part of their comprehensive asset allocation. 
4. US dollar-denominated global bonds offer a compelling diversification component, as measured by their high Sharpe Ratio metrics and favorable returns. However, the asset class does have higher volatility, as measured by standard deviation. 

During times of major economic shifts, as some speculate that we are facing now, it may be tempting for investors to dramatically de-risk or add risk to their portfolios. This is especially true for bond investors who have been “taught” to expect diminishing returns from their portfolios in a rising rate environment. The analysis above will hopefully demonstrate to some of these investors that modest adjustments to a diversified portfolio allocation can often be more effective than dramatic changes.

Related: When Rates Rise, It Probably Won't Be in Alarming Fashion