The U.S. dollar has benefited from the risk aversion generated by COVID-19. But longer term, is the greenback ahead of itself?
Earlier this year, ominous signs as the virus spread in China had scant impact on the dollar’s value. But by the second week in March, demand for the currency surged and liquidity cratered, prompting the Federal Reserve (Fed) to expand liquidity in unprecedented forms and amounts. As a result, the Fed’s balance sheet shot up from $4.24 trillion the week of March 4 to $6.93 trillion the week ended May 13,1 with little end in sight.
Brandywine Global’s Richard Lawrence observes that in the short term, the dollar has likely stabilized:
“In our view, short-term currency performance tends to be driven by factors such as momentum, risk appetite, sentiment, and liquidity. Given that uncertainty—what we call “information risk”—remains elevated, it is likely that risk aversion keeps the dollar in demand. For now, the Fed seems to have done enough to relieve the worst of the dollar squeeze, although probably not enough to push the dollar into a sustained declining trend. Therefore, our near-term view is that the dollar may stay firm but should not appreciate meaningfully from here. Furthermore, as countries around the world start to re-open their economies, we would expect dollar demand to ease somewhat.”
(Excerpted from The Dollar Is King…or Is It?)
But the picture looks quite different when viewed from the perspective of valuation:
“Over the longer term, we view measures of value as influential in determining currency performance. So metrics such terms of trade and purchasing power parity (PPP) come into play. These metrics currently suggest that the dollar remains extremely overvalued, and therefore argues for the dollar to decline (Chart). With that said, the dollar has remained overvalued on a PPP basis for five years now, coinciding with—and arguably resulting from—the Trump candidacy and presidency. This implies that the 2020 election may play a significant role in determining the path of the dollar after November.”
U.S. Dollar Index
* Based on GDP-Weighted PPP of 6 Countries: Eurozone, Japan, UK, Canada, Switzerland, Sweden.
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.
But valuation is only one of several factors affecting the long-term prospects for the dollar. Others include productivity differentials, structural reforms, foreign direct investment, and fiscal dynamics. As for dollar liquidity and the ultimate course of the dollar:
“…we can be confident that the Fed will lean against further dollar demand, but the longer-term outlook remains clouded with uncertainty. Over the next few quarters as economies restart, we will be looking for clues on who are likely to be the winners and losers in what is expected to be an extended and uneven global recovery.
Beyond that, in addition to valuation, politics, geopolitics, and fiscal dynamics will possibly come into play for the dollar’s trajectory. Will the dollar be king? Only time will tell.”
1 Source: Federal Reserve via Bloomberg, March 19, 2020.
The DXY Dollar Index measures the value of the U.S. dollar relative to the exchange rates of six major world currencies (the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc) which represent a majority of its most significant trading partners.
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.
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.
Purchasing Power Parity (PPP) is an economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.