Uncertainty is the predominant theme currently in the markets. Unfortunately, there are more questions than answers. No one quite knows what tomorrow may bring. It has certainly made gauging future market activity more interesting. Because of this uncertainty there have been many contrary views of currency markets and taking a view has become more difficult.
The U.S Dollar has come off the highs seen in March of this year. The DXY index (which is a measure of the value of the United States Dollar relative to a basket of foreign currencies) traded just shy of 103.00 during March, and currently trades around the 97.00 level. During this period, the Dollar strength could partly be attributed to the relative resilience of the US economy which in part was driven by a late start to state-wide shutdowns in the U.S. This Dollar strength was further exacerbated by a Dollar liquidity shortage, as the demand for US dollars abroad surged. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. See Figure 1.
The U.S. economy is a relatively closed economy and as such has benefited in the past when services activity output was stronger relative to manufacturing activity output. The COVID-19 pandemic has led to the services sector being hit harder due to social distancing measures. The recovery of this sector is also likely to be more drawn out.
For example, restaurants and hospitality are unlikely to retrace back to their pre-crisis peaks anytime soon, whereas construction and manufacturing may do so sooner. The key message is that global manufacturing activity is thus far holding up better than services activity, and activity in general is picking up faster outside of the U.S. This has historically seen a rise in procyclical currencies and in turn a weaker Dollar. In order for global manufacturing activity to recover, it requires that confidence held by consumers and businesses rise and that it capitalises on the favourable financing conditions that have been created in the markets via the Central Banks and Governments in response to the pandemic. There is some evidence that this confidence is growing outside the U.S. One of the metrics being watched is the velocity of money, which is the rate at which money is exchanged in an economy. The velocity of money in Germany for example, has stopped falling relative to the U.S. Global industrial activity remains quite subdued, but it appears that sentiment among German investors is very upbeat for the post-COVID recovery. This has usually been a good barometer for an improvement in PMIs. See figure 2.
Balance-of-payment dynamics are increasingly bearish for the US dollar. U.S interest rate differentials between its peers have narrowed following the Federal Reserve’s aggressive monetary easing in response to the stress on the U.S economy. As a consequence of narrower interest rate differentials, the U.S capital account surplus is likely to recede and the resulting balance of payment deficit will put selling pressures on the Dollar when industrial activity increases. Now, in order to balance our vie
w on the Dollar, we look at some of the factors which support a more bullish view.
As the reserve currency, the Dollar tends to do well during periods of heightened uncertainty. With a clear risk of a second COVID-19 infection wave, and with equity markets up strongly from their lows, odds are that volatility could rise in the near term and support a stronger Dollar. Geopolitical tensions continue to mount between the U.S. and China which together with the upcoming U.S presidential elections are key sources of risk. Historically, the Dollar has tended to rise when equities and risk premia are up. See figure 3.
When we look at the valuation of the Dollar, it is clearly expensive relative to certain currencies such as the Swedish Krona and the Norwegian Krone to name a few.
However, on a trade-weighted basis, the dollar is only one standard deviation above BCA’s fair-value model. This still makes the dollar expensive, but not to the extent of the extremes seen in the past that have tended to occur around two standard deviations above fair value. See figure 4.
This fair value model has two key inputs, the productivity gap between the U.S and its trading partners as well as real bond yield differentials. Rising productivity ensures a country can pursue non-inflationary growth. This lifts the neutral rate of interest in the country, raising the long-term fair value of its exchange rate. The last factor which
may pose a risk to the Dollar bearish view is that of a post COVID-19 world. We may well see an increase in geopolitical tension together with an increase in nationalisation. Trade agreements may be tested (as has already been seen between the U.S and China as well as between the U.S and Europe), which would disrupt any prospect of a rebound in global growth. With the U.S being an enormous consumer and with consumption representing a larger share of GDP compared to exports, a change in productivity dynamics (where the U.S moves to more domestic production for example) would disrupt capital flows which has previously dictated the Dollars countercyclical nature (where the Dollar tends to weaken when global growth is high relative to U.S growth).