August is set to mark the fourth straight monthly decline for the U.S Dollar. The recent dovish statements from Federal Reserve Chairman Jerome Powel on U.S interest rate expectations and targeting higher levels of inflation has placed further pressure on the Dollar. Recent surveys on sentiment towards to Dollar have shown that bears outnumbered the bulls. See Figure 1.
In this edition of Your Monthly Wau! we look at the path ahead for the Dollar considering the policy adoptions and the dynamics facing the U.S.. A weakening of the Dollar can either be a risk-on or a risk-off event. This is similar to the way bond yields fall when monetary policy turns dovish (risk-on) or fall when deflationary pressures set in (risk-off). This often feels counterintuitive and makes gauging price movements challenging. Historically however, the Dollar has traded as a risk-off currency. The reason for this is partly because the U.S. Treasury market is one of the most liquid and safest in the world. When investors panic, they flock to U.S Treasuries, which raises the demand for the Dollar and therefore the price rises in response to the higher demand. In contrast, when investors feel more comfortable and are willing to take on more risk, they tend to exit U.S Treasuries and sell Dollars i.e. lower demand leading to a lower price.
The U.S economy is less cyclical than those of its trading partners. See Figure 2.
This means that although the U.S benefits when stronger global growth prevails, it does so less than other economies outside the U.S.. When we see a rise in global growth, capital tends to flow out of the U.S into other parts of the world which reduces the demand for and weakens the Dollar. Interest rate differentials (the difference in interest rates between two similar interest-bearing currencies) are stacked against the Dollar. In 2019, the euro area 2-year real interest rates were 221 basis points below comparable U.S. rates. Today, they are 19 basis points above U.S. interest rates, representing a change of 240 basis points. A change like this in interest rate differentials affects the value of a currency as capital tends to flow to those economies with higher interest rates. Balance of payment dynamics are another factor worth considering when looking at the value of a currency.
These dynamics are becoming ever more important drivers of currency values because of the huge influx of monetary and fiscal stimulus in – response to the economic fallout from COVID-19. The pandemic has undoubtedly caused a disruption in international trade. Global trade volumes plunged by 5% in the first quarter of 2020 and are expected to be down 27% in the second quarter relative to their levels in the final three months of 2019. See Figure 3.
Moreover, the path of recovery remains uncertain as the pandemic continues to disrupt global supply chains and weaken consumer confidence. COVID-19 may represent a tipping point in this respect as investors become more discerning between countries and sectors with a high return on capital and those without. The U.S basic balance (which takes the sum of the current account and net long-term capital inflows) is deteriorating. The key driver has been the decline in foreign direct investment in the U.S..
The U.S. remains the world’s largest foreign direct investment (FDI) recipient, attracting $261 billion in 2019, which is almost double the size of FDI inflows into the second largest FDI recipient, China, with $141 billion of inflows last year. However, cross border flows have dropped since the effects of the 2017 tax break have subsided, together with the lack of any meaningful merger and acquisition deals in the U.S.. Despite Trump’s push to reduce the U.S trade deficit the trade balance remains fairly unchanged. Although the trade deficit with China did drop by 21%, U.S. companies simply sourced from alternative countries not affected by the newly imposed tariffs such as Vietnam and other countries in South East Asia. More recently exports have plunged much faster than imports, further widening the U.S. trade deficit and Treasury International Capital data has shown weak investment into U.S Treasuries by foreigners. These dynamics further reinforce the bearish view on the Dollar. See Figure 4.
At the recent Jackson Hole summit, Jerome Powell reiterated the Federal Reserve’s dovish position. The Federal Reserve will be targeting an average inflation rate of 2% over the long term, and so will allow inflation to overshoot 2% in order to make up for the periods where inflation undershot the target. This means that the Federal Reserve is extremely unlikely to be raising rates anytime soon. In the words of Jerome Powell: “we’re not even thinking about thinking about raising rates”. There is still a great deal of uncertainly around the pandemic and the recovery of the world’s economies. However, we have started to see economies begin to reopen and so growth should receive a welcome boost over the next few months. Over the next twelve months, we should see a weaker Dollar which will mainly stem from stronger global growth as more and more economies reopen together with low U.S interest rates brought about by a very dovish Federal Reserve.