Are the US dollar’s days of dominance done?
Are the US dollar’s days of dominance done?
After rising sharply at the beginning of the Covid-19 crisis, the US dollar has weakened in the second half of 2020. Investors are now wondering if this could be the beginning of a major trend that could see the dollar weaken substantially, after a long period of strength.
Here, we look at some of the headwinds that could lead to a further weakening of the dollar.
First headwind: trade imbalances
With US oil production now in retreat, the weakness on the non-petroleum side of the trade balance has become more concerning, as gains in oil exports can no longer mask the issues with the broader trade balance. This could spell trouble for the current account and consequently the dollar.
The Covid-19 shock has led to large swings in the US current account. Similar to the financial crisis, the trade balance improved sharply in early 2020, with imports falling more than exports because of a collapse in consumption and investment.
However, very expansive US fiscal policy, in the form of stimulus cheques and extended unemployment benefits, has been far more supportive of consumption. The result of this different kind of crisis response has been a fast recovery in economic activity.
This in turn has led to a spectacular U-turn in the current account balance. Fast widenings of the current account deficit have tended to be associated with periods of notable dollar weakness. Against that backdrop, it is not surprising that the dollar has weakened.
Second headwind: structural budget deficit
While the cyclical component of the US budget deficit is likely to narrow once the effects of the Covid-19 stimulus subside, the non-cyclical or structural deficit is likely to remain substantial.
To entice foreign investors in the face of a deteriorating fiscal situation, a country can either hike interest rates or let its currency weaken, making its bonds cheaper for overseas investors to purchase.
The Federal Reserve (Fed) has said that it does not intend to increase interest rates any time soon under its new average inflation targeting policy. Central banks normally have less of control on the long end of the yield curve, so a sell-off in the long-term Treasury yields would make holding dollars more attractive per se.
However, given the high and growing debt loads in the US, the Fed could be forced to fix yields further out in the yield curve, reducing the efficacy of this automatic stabiliser.
Investors, faced with deterioration in the fiscal condition, in the absence of higher bond yields, would then need a lower dollar to incentivise them to purchase US bonds.
Third headwind: possible end of American “exceptionalism”
Because the Fed has cut US interest rates to zero and the US economy has been particularly scarred by the pandemic, American exceptionalism has been called into question. Thus, it is possible that some of the inflows will reverse.
The US does have the privilege of issuing the reserve currency of the world, so it might get away with policies that would be untenable for most other countries. However, this privilege is not set in stone, as the reserve currency status has changed over time. Should the persistent budget deficit and the continuing Fed balance sheet growth stoke fears of outright debt monetisation (financing of budget deficit by central bank), this could eventually lead to selling of US assets by global reserve managers.
Granted, the structural changes in the dollar’s reserve currency status would likely take years to play out. In the near term, the direction of the dollar depends on the broader supply and demand for the US assets.
- The Zero: why interest rates will stay low
- GameStop: the ethics of short sellers
- How climate change could impact investment returns over the next 30 years
- What can investors expect from the Year of the Ox?
- The “three Ps” that are crucial for sustainable investing
- Is the UK heading for a double-dip recession?
Any security(s) mentioned above is for illustrative purpose only, not a recommendation to invest or divest.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.
Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. Exchange rate changes may cause the value of the overseas investments to rise or fall. For risks associated with investment in securities in emerging and less developed markets, please refer to the relevant offering document.
The information contained in this document is provided for information purpose only and does not constitute any solicitation and offering of investment products. Potential investors should be aware that such investments involve market risk and should be regarded as long-term investments.
Derivatives carry a high degree of risk and should only be considered by sophisticated investors.
This material, including the website, has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.