Downward dollar: why the greenback's decline could continue
Downward dollar: why the greenback's decline could continue
It has been a rollercoaster few months for financial markets amid the Covid-19 pandemic. The US dollar, as it often is, has been a central player in the story.
At the peak of the crisis in March, the currency spiked by nearly 10% in just ten days on the back of broad-based demand. The move was fuelled by global institutions desperate to acquire the greenback in order to meet their US dollar liabilities.
The search for safe havens amid the turmoil, along with panic buying, was evident as US dollar funding rates moved aggressively higher.
The dollar’s trajectory has since reversed course, weakening by about 10% since its March peak. After such a rapid move there is potential for a period of consolidation, and there could be dollar strength if the resurgence of Covid-19 over the winter months weighs on economic activity.
We are generally of the view, however, that the fall we have witnessed since March is just the beginning. We expect a more meaningful US dollar downtrend over the medium to longer term.
Here are some of the key factors behind this.
Factors to watch
There is little doubt that recent US dollar weakness can be partly attributed to the huge policy response to the Covid-19 crisis and the resulting improvement in economic data. This, combined with the abundance of liquidity, largely explains the bounce-back in risk assets, which has correlated with US dollar weakness.
What’s more, since the pandemic escalated, Asia and Europe have controlled the virus more successfully than the US. So not only has global activity rebounded from depressed levels, but the rest of the world has picked up more robustly than the US, narrowing the growth differential.
We would also add that the recovery to date has been extremely uneven, with goods outperforming services, which has contributed to some economic outperformance in favour of Asia and Europe. Additionally, US rates have converged toward those of others countries as can be seen in the bottom half of the second of the charts below.
Given the continued uncertainty of Covid-19 and the fragility of the recovery, central banks and governments clearly see expansive fiscal policy and highly accommodative monetary measures as essential.
We believe that the €750 billion European Recovery Fund to support the region in the face of Covid-19 will lead to structural improvements for European growth. It demonstrates strong political will to support the European project and a small, but important step towards a true economic union, allowing fiscal transfers.
The closer integration this brings, crucially with the assurance of stronger support for economically-weaker members, arguably makes Europe a more viable lower-risk or safe haven alternative to the US. The recovery fund includes ambitious proposals for investment in areas such as digitalisation and the green economy, which could boost long-term productivity growth in Europe.
Additionally, there is the increased uncertainty around the looming US presidential election. It has the potential for negative implications for US assets and the currency, not least as the concept of US exceptionalism could be brought into question under Democratic leadership.
The global liquidity cycle
Given the majority of global trade, commodities and global debt, in particular across emerging markets, are priced in US dollars, access to reasonably priced dollars is essential for financial institutions and companies.
The sharp spike in the dollar exacerbated the crisis at its peak, as a scramble to ensure sufficient supplies contributed to unprecedented demand.
We think there are four key factors to consider in terms of the dollar’s outlook: funding, interest rates, relative performance of US assets and the Federal Reserve balance sheet.
Funding: One reason US dollar hoarding occurred is that dollar liabilities of non-US banks grew significantly after the 2008 financial crisis. The Federal Reserve (Fed) along with other global central banks are committed to ensuring this dollar squeeze does not reoccur, implementing swap lines and a global repo facility. The Fed recognises the importance of US dollar liquidity by lowering the cost for banks to access dollars and extending the global swap lines at the July Federal Open Market Committee meeting.
Interest rates: Following rate cuts by all major central banks, but especially the Fed, interest rate differentials across countries are now negligible. The US dollar has effectively lost the yield advantage which has been in place for several years.
Relative market performance: For a number of years investors have favoured US assets due to the US’ superior growth, both in terms of GDP and corporate earnings. We have seen various client types purchasing dollar assets even on an unhedged basis, due to the growth and yield advantage. This has been a pronounced and forceful trend for some time, but we believe that we are now in the early stages of its reversal.
Relative balance sheet and quantitative easing: G4 central bank balance sheets have expanded by nearly $5.7 trillion since February, equivalent to 16% of combined G4 GDP. The Federal Reserve’s balance sheet expansion has been comparatively small, but still aggressive. Its commitment to buy corporate bonds and increase Treasury purchases has supressed volatility. An aggressive expansion in the US monetary base, and resulting lower volatility, typically indicates a weaker US dollar.
The Federal Reserve has communicated that it will be altering its policy framework to allow the economy to “run hot”, with potentially above target inflation. The Fed will want to prevent the easing initiative being unwound by markets by keeping real yields (bond yields minus inflation expectations) lower. They could potentially use more aggressive forward guidance, quantitative easing and ultimately yield curve control.
If the Fed adopts such a policy in isolation this would further undermine the US dollar. With inflation expectations picking up, we have noted a rising correlation between US real yields and the dollar (see second chart below).
We believe the long term trend for the US dollar depends on the speed at which “de-dollarisation” occurs. The principal determinant of this is whether a viable alternative or alternatives emerge to act as the world’s reserve currency.
This includes a probable shift towards less dependence on the US dollar as the preferred currency for international transactions and commodities being priced in other currencies. While difficult to time, it seems increasingly likely that markets and governments will seek a degree of diversification from the US dollar.
Potential accelerants of this trend would include more competition in derivative based trading, structural changes in energy markets which are priced in alternative currencies and continued opening up of China’s financial markets. China is set to account for 20-25% of the global bond market over the next few years, the same size as the US.
This could also accelerate if Europe meaningfully pushes the integration of the 19 members of the euro currency. The European Recovery Fund is a significant step. Deposit insurance and steps to strengthen the banking sector would be important further developments. Should these occur, it seems highly likely that the euro would take some of the reserve status from the US dollar. Overall, there is some evidence that a 5-10 year process of de-dollarisation has started.
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