In focus

Does the US dollar have further to fall?


After falling in the second half of 2020, the US dollar has shown more resilience this year. Given the importance of the dollar for markets, the question now is if the recent stability signals the end of dollar weakness or if further depreciation is on the cards.

In the near term, the dollar’s fate will hang on the willingness of foreigner investors to purchase US bonds and other assets on the back of the sharp increase in US yields.

US current account deficit is likely to increase further

One of the key reasons for the dollar’s weakness since mid-2020 has been the widening of the US current account deficit. The deficit has increased mainly because of the sharp deterioration in the trade balance, with US imports recovering much faster than exports from the Covid-19 induced slump.

On 11 March, US President Biden signed the $1.9 trillion stimulus package into law. Looking ahead, the $1,400 stimulus checks would have gone out. Furthermore, US households have accumulated significant savings in the Covid-19 crisis. As the economy continues to open up, at least some of these savings will be spent. This will add more fuel to the fire, meaning that the US current account deficit is likely to start widening again after rising from 2% to 4% of GDP in 2020.

What level of current account deficit is sustainable?

The large fiscal stimulus and the relative success of the US vaccination campaign means that the country is ahead of most other countries in the pandemic recovery. The US is likely to outgrow other developed market countries in 2021.

This is good news for growth-sensitive assets, such as equities, perhaps less so for the dollar. In fact, faster growth, if financed by an increase in budget deficit, often leads to a weaker currency. This has been a staple relationship in emerging markets, where weaker currency is often a payback for faster growth.

Greater spending, at least in the short-term, tends to increase imports and widen the current account deficit. If the foreign demand is insufficient, the currency will have to bear the brunt and weaken, in order to make the two sides of the balance of payments to equalise.

While clearly, the US differs from other countries because of the reserve currency status of the dollar, it is still affected by the same forces. Furthermore, the US had a significant structural budget deficit even before the Covid-19 crisis, so additional spending has only magnified the issue.

Fed’s policy is reducing the efficacy of stabilisers

Fiscal and monetary policy are, in essence, two sides of the same coin. If one is loose, the other generally has to be tight and vice versa. This works as a stabilising mechanism.

However, the Fed’s framework of average inflation targeting means that this stabilising mechanism is impaired. At the Federal Open Market Committee meeting on 17 March, the Fed indicated that it does not see a need to increase interest rates until at least 2024.

So far, the Fed has been sanguine about the developments with the long yields. However, it’s possible that the they will try to quell the rise in long-term yields. Such a policy would reduce the yield advantage of US assets and support for the dollar.

Looking further ahead, the fiscal policy is leading to a wider current account deficit. Unless foreign demand for US assets, especially US Treasury bonds, increases materially, financing of that deficit might require a weaker dollar.

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