Around the Curve

Dollar Outlook Dims

By Anujeet Sareen, CFA, Portfolio Manager
20 August, 2020

We believe the four key forces supporting the dollar are in retreat.

So far, 2020 has been a volatile year for financial markets, and the currency markets have been no exception. The U.S. dollar advanced nearly 9% in the first quarter before giving back almost two-thirds of its rally as of the middle of August. After declining nearly 5% at one point in the first quarter, the euro is now up 11% from its March lows. The Australian dollar fell 18% in the first quarter and has since rallied 25%. The Mexican peso fell 27% in the first three months and has since rallied 15%. Unlike developed market currencies, emerging market currencies, in general, have not yet recovered their losses. As far as what may drive the U.S. dollar going forward, there are both shorter-term and longer-term factors to consider.

What Drove the First Quarter Dollar Rally?

Before looking forward, it is important to understand the factors that influenced currencies, particularly the U.S. dollar, in the first half. The dollar's first quarter rally was driven by four factors. The first factor was the path through which the pandemic impacted the world. China was hit first, then Korea, and their economies were the first to slow. Next came Europe, notably Italy and Spain. Then, the pandemic spread to the U.S. In terms of sequencing, the U.S. economy initially outperformed the rest of the world in 2020, and consequently, the dollar appreciated against most currencies as well. The second factor that supported the dollar was the higher level of U.S. interest rates compared to developed markets and even some emerging markets. Third, the sharp flight to quality in March supported U.S. dollar appreciation as investors focused on capital preservation in safe-haven Treasuries. Essentially, one of the safest currency markets in the world offered the highest interest rates in the world.

The fourth factor driving currencies was very specific to this environment—the pandemic was an extraordinary income shock that created severe financing stress. In comparison, the Global Financial Crisis (GFC) in 2008 was largely a funding shock. The GFC centered on a problematic banking system and overleverage; companies, banks, and individuals borrowed too much money, and banks were unable to facilitate normal lending. This time, the banking system was not source of the problem. The challenge was not so much the availability of credit as it was the collapse of income—revenue disappeared overnight as the world went into lockdown during March and April. And, the impact was indiscriminate. Even high-quality companies with modest liabilities struggled to generate sufficient U.S. dollar revenue to meet their debt obligations. As revenues disappeared, there was a desperate scramble to find U.S. dollar financing to roll over existing obligations until revenue normalized.

Short-Term Supports for the Dollar are Dissipating

These factors driving the dollar have largely reversed. The pandemic stabilized in Asia and Europe, ahead of the U.S. Growth started recovering first in China and South Korea with a similar story in Europe. The U.S. recovery has lagged those recoveries, and the particularly acute “second wave” in the U.S. is amplifying the growth lag between the U.S. and the rest of the world. Secondly, the Federal Reserve (Fed) slashed interest rates to zero, so there is no longer an advantage to holding dollars relative to other markets. The Fed also pursued a large range of unconventional policies to expand the supply of money and credit for the economy. Measures of money supply have expanded rapidly—through the end of July, M1 grew 38% over the previous year, the strongest growth rate of money supply in 80 years. The sharp rally in gold and gold equities reflects this monetary development. The Fed has succeeded in not only reducing the price of money (interest rates) but has also succeeded in rapidly expanding the supply of money. Both factors are negative for the dollar. 

Chart 1: U.S. Monetary Aggregates

M1, SA, %YoY, as of 7/31/2020

Sources: Brandywine Global, Macrobond, Federal Reserve. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The flight to quality is also reversing as the pandemic stabilizes and confidence returns. Lastly, the Fed went out of its way to alleviate dollar-funding pressures with the expansion of dollar-lending facilities through swap lines to foreign central banks. As the negative growth effects of the virus subside and the global economy recovers, the U.S. dollar is likely to weaken further, particularly against the more growth-sensitive currencies of emerging markets.

The Longer-Term Dollar Story

Beyond the dollar's cyclical path, its longer-term drivers are worth considering at this point. The current dollar bull market, which began in 2011, has been supported by two major factors. The first is growth leadership. U.S. dominance in technology, notably in high-profile “soft” tech companies, has been a key reason for U.S. growth outperformance. While the rates of U.S. growth and productivity growth have not been as strong as the economy experienced in the late 1990s and the technology boom during that decade, it is nevertheless the case that the U.S. economy has notably outperformed the major regions around the world. For this reason, the Fed was the only major central bank to embark on a cycle of meaningful rate hikes from 2016 to 2018. The strength of the U.S. economy was unmatched elsewhere, and other central banks were unable to pursue a similar scale of monetary tightening.

Chart 2: Equity U.S./World

As of 8 /17/2020

Source: Bloomberg Finance/Haver Analytics. Past performance is no guarantee of future results.This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The second factor during this expansion has been the resilience of the U.S. current account balance. Normally, when the U.S. economy outperforms and the dollar appreciates, the external account deteriorates as the U.S. imports more, reflecting stronger domestic income growth and cheaper foreign goods, and exports less, losing competitiveness from a stronger dollar. However, over the past decade, the U.S. current account has remained stable at around -2% of gross domestic product (GDP). There are two factors behind this resilience. One, the U.S. energy trade balance has improved significantly over the past decade, largely offsetting any deterioration in the goods trade balance. The material increase in energy production from shale gas and oil has allowed the U.S. to “spend” this income without leading to a deterioration in the external balance. Two, the U.S. net income balance is still closest to its highest surplus in history, i.e., the U.S. received more income from its investments and loans abroad than it pays on its obligations to foreigners' investments and loans.

Chart 3: Balance on Current Account

% of GDP, SAAR, as of 8/15/2020

Source: Bureau of Economic Analysis / Haver Analytics. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Chart 4: U.S. Energy Trade Balance

% of GDP, as of 8/15/2020

Source: Haver Analytics. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Chart 5: U.S. Net Income Balance

% of GDP, as of 7/20/2020

Source: Haver Analytics. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

In summary, we believe the current dollar bull market has been driven by stronger U.S. growth, led by technology, and a more resilient external balance. However, the dollar story may be changing for other reasons.

The first longer-term theme that has turned negative for the U.S. dollar is political. Policymakers have effectively crossed the Rubicon with respect to Modern Monetary Theory (MMT). Alongside a rapid expansion of the fiscal deficit, the Fed has commensurately expanded its balance sheet. Through the second quarter, U.S. real personal income grew at its fastest pace ever. If one was unaware that the U.S. was experiencing its worst recession in nearly 100 years, income growth would have suggested the economy was booming. As the money supply chart above indicated, the Fed provided all the monies needed for the government to send out that support. However, MMT is a longer-term negative for the dollar. Moreover, the current polling leader for the U.S. presidential election, Joe Biden, is campaigning on a platform to raise corporate taxes. Just as the lowering of taxes boosted growth and the dollar in 2018, an increase in corporate taxes in 2021 will likely discourage capital inflows into the U.S., weakening the dollar.

Meanwhile, the political winds in Europe and China have moved in different directions. The eurozone has taken an important step toward fiscal union. Germany has finally gotten off the fence and recognized the need to help member states without conditionality, offering to assist the hard-hit countries of Southern Europe with grants and not just loans. In the same way that New York and California taxes moved seamlessly through the federal government to help states ravaged by Hurricane Katrina, Europe has formalized a similar mechanism for the COVID-19 crisis. This is a pivotal change for Europe, a step toward fiscal unity, and a positive for the euro. Meanwhile, Chinese authorities have taken a much more measured approach to using monetary policy to respond to the pandemic. China rapidly expanded money supply and credit following the GFC in 2008 and the commodity collapse in 2016. Both periods, however, led to a rapid increase in debt levels and misallocations of capital. This time around, China has moved more carefully, and money supply and credit growth have accelerated more modestly. In relative terms, U.S. monetary policy is far looser than Chinse monetary policy, a negative for the dollar.

The second factor that has turned negative for the dollar is the more structural impact of the virus on the U.S. economy. While a variety of factors explain why some countries experienced more significant outbreaks than others, one common factor appears to be the size of the service sector.

Chart 6: COVID-19 Cases Per 1M Population

%YoY, as of May 2020

Source: Macrobond. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

This relationship makes sense considering the service sector relies on interactions between people, providing more scope for transmission—and the U.S. has one of the largest service sectors in the world. Unlike any recession post-WWII, the current recession is primarily a service sector recession. As the virus subsides in response to treatments, supplies, and ultimately a vaccine, the service sector will recover, and unemployment will decline. However, the impact of the virus on the economy will last well beyond the development of a vaccine. We are learning through the corporate world to what extent employees can operate from home. We also are finding other ways for interacting, reevaluating commercial real estate needs, and seeing restaurants operate differently. These changes and others like them mean there are service sector jobs that are just not coming back, and that should hurt the U.S. more than economies that are more manufacturing heavy. The U.S. might have to contend with an elevated unemployment rate for longer until those individuals find different jobs and different training for different industries. That is a reason for the Fed to be somewhat easier relative to other central banks around the world, which should weigh on the dollar.

Chart 7: USD vs. Unemployment Spread

As of 7/31/2020

Source: Haver Analytics. Past performance is no guarantee of future results.This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Weaker Outlook for the Dollar

In summary, we believe the dollar is likely to weaken further over the medium term. The movement toward MMT, the divergent political transitions in the U.S., Europe, and China, and most importantly, the prolonged structural adjustment still ahead for the U.S. service sector are likely to weigh negatively on the dollar for some time. Admittedly, the U.S. current account has not shown the erosion in competitiveness that marked the 1980s and 1990s bear markets. Furthermore, U.S. leadership in the technology sector remains robust. However, these factors are more likely to limit the degree of U.S. dollar weakness than change the overall negative path for the dollar ahead.


Definitions:

Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

safe haven is an investment that is hoped to retain or increase in value during times of market turbulence. Safe havens are sought by investors to limit their exposure to losses in the event of market downturns.

Seasonal adjustment (SA) removes the effects of recurring seasonal influences from economic series. Seasonally adjusted data are referred to in a number of ways: adjustedseasonally adjusted, and SA. Annual rates that are adjusted for seasonality are referred to as seasonally adjusted annual rate (SAAR). Likewise, data that have not been seasonally adjusted are often referred to as not seasonally adjustedunadjusted, or NSA.A swap line is another term for a temporary reciprocal currency arrangement between central banks. That means they agree to keep a supply of their country's currency available to trade to another central bank at the going exchange rate. Banks use swap lines for overnight and short-term lending only.

spread is the difference in yield between two different types of fixed income securities with similar maturities; usually between a Treasury or sovereign security and a non-Treasury or non-sovereign security.

The real effective exchange rate (REER), also known as the FX (foreign exchange) REER, is the weighted average of a country's currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's currency against each country within the index.

The Organization for Economic Co-operation and Development (OECD) is an international organization that promotes policies to improve the economic and social well-being of people around the world.

Gross Domestic Product (GDP) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

current account balance summarizes the flow of goods, services, income and transfer payments into and out of a country

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

The Great Recession, also known as the financial crisis of 2007–08, the Great Financial Crisis (GFC), global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

M1 Money Supply is the money supply that includes physical currency and coin, demand deposits, travelers checks, other checkable deposits and negotiable order of withdrawal (NOW) accounts.

Modern Monetary Theory (MMT), not widely accepted, has the following basic attributes: A government that prints and borrows in its own currency cannot be forced to default, since it can always create money to pay creditors. New money can also pay for government spending; tax revenues are unnecessary. Governments, furthermore, should use their budgets to manage demand and maintain full employment (tasks now assigned to monetary policy, set by central banks). The main constraint on government spending is not the mood of the bond market, but the availability of underused resources, like jobless workers.

The eurozone, officially called the euro area, is a monetary union of 19 of the 27 European Union (EU) member states which have adopted the euro (€) as their common currency and sole legal tender.

COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARS­CoV-2.

World War II, also called Second World War, conflict that involved virtually every part of the world during the years 1939–45. The principal belligerents were the Axis powers—Germany, Italy, and Japan—and the Allies—France, Great Britain, the United States, the Soviet Union, and, to a lesser extent, China. The war was in many respects a continuation, after an uneasy 20-year hiatus, of the disputes left unsettled by World War I. The 40,000,000–50,000,000 deaths incurred in World War II make it the bloodiest conflict, as well as the largest war, in history.

 

  

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