By Holly Lobprise
One of the few things you could depend on in the past few months of uncertainty was the strength and safety of the US dollar. The market for the dollar reflected the flight to safety, as the dollar index spiked 8% over only ten days at the height of the market turmoil.
But as the world tries to get back to ‘normal’ and all asset classes with it, what does ‘normal’ mean for the dollar? Will it continue to out-perform, or has it been too strong for too long?
The dollar in hindsight
An overvalued greenback is not a 2020 phenomenon. The dollar index has been elevated since 2015, when the dollar rose at its fastest rate in 40 years. This was triggered by the American economy’s relative strength in a global environment of slowing growth rates, interest rate cuts, and stimulus programs.
Many pundits have been predicting the weakening of the dollar for years due to the size of the US current account deficit. They argued that the burgeoning prevalence of the Yuan or some other economic metric would not allow the dollar to stay strong indefinitely.
These headwinds have not abated. Why then has the greenback not given up any ground after its 2015 surge?
One reason was the economic growth the US enjoyed in the past few years. Although the pickup in EU area growth dented the dollar index in 2017 and 2018, ultimately US growth prevailed.
Another support for the dollar has been relative interest rates. The same economic growth that elevated the currency in 2015 allowed the Fed to raise rates towards the end of the year. Implementing a rise in rates at a time when other economies were still trying to pump stimulus meant the dollar offered above-average carry among G10 currencies, which was a draw for capital.
The dollar in the pandemic
The dollar has also out-performed during the Covid-19 crisis.
During a crisis, the job of global governments, and especially their central banks, is to try to provide liquidity at a time when everyone’s risk appetites are crashing. The demand for dollars created by the worldwide pandemic was urgent and significant, and it took the Fed trillions of dollars, and now ‘unlimited’ stimulus to sate that appetite.
The dollar in flux
As rational as it seems for the dollar to have out-performed during the extreme market stress of the last few months, it also seems reasonable that its elevated valuation might be due for a reversal. The timeline for such a reversion is uncertain, however, as there are numerous events that might delay the fall of the dollar.
The second wave of coronavirus, which indeed already seems to be happening in the US, could see another flight to safety assets. Considering the equity market rebounds we’ve already seen, it’s evident that there has been a lot of capital redeployed to risk assets that could flow back into the dollar if risk sentiment turns again.
A reignition of the US-China trade war could also see dollar stability return, as in this dispute the Yuan is the currency that acts as the adjustment mechanism. Allowing the Yuan to weaken was one of the Chinese government’s tools to offset the impact of American tariffs.
The dollar in retreat
Looking past these topical concerns, however, there is evidence that the foundation for the dollar’s strength over the past few years is eroding.
One of the conditions that has played a part in dollar strength has been the yield premium. That was diminished earlier this year when the Fed cut rates by over 85%. Although the US still maintains superior yields compared to many other developed countries, the draw of the dollar as a tool of the carry trade has significantly lessened.
The greater growth outlook the US enjoyed up until 2020 has also been diminished by the global recession, especially as areas like China and the EU have weathered the pandemic better. We can expect that the resurgence of the virus within America’s borders will slow its return to normal and dent the confidence in the US currency.
The decline in growth also means that the world is in a different stage in the economic cycle now. The early phase of a new cycle, characterised by expansions in growth, is typically an impetus for commodity prices which move inversely to the Dollar.
The uncertain growth trajectory for the US economy is compounded by political certainty as the US election looms. That could lead to a potentially messy transition and policy reversals that could weigh on the greenback.
Another source of ambiguity for the dollar is other countries’ Covid-19 relief measures. The large current account deficit that the US has been running was regarded as one of the most potent catalysts for the dollar to weaken, as a large deficit means a higher supply of dollars in the market.
Although the US government and the Fed have considerably expanded their balance sheets to combat the economic downturn, so have other governments around the world. This means that more of their currencies are in circulation too. The actions that would have unilaterally softened the dollar have therefore been offset by other market players.
The dollar in the future
Although the environment in which the dollar now operates seems unfavourable for continued strength, it is unlikely that we will see a deep bear market for the greenback either. The yield premium over other G10 currencies has not disappeared, and the chance of further market instability tempers the confidence in a dollar drawdown.
Any softening of the dollar does not jeopardize its standing as the world’s reserve currency. We are not, therefore, looking at the end of an era but rather an adjustment to the status quo.
Holly Lobprise is senior analyst at Cinnabar Investment Management.