Is this the Dollar’s Tipping Point?

by Sean Tweedie | July 31, 2020

The U.S Dollar has reigned supreme over the greater part of the last decade. A strong domestic economy, favorable interest rates and the status of being the reserve currency of the world has underpinned much of the Dollar strength. Over the course of this year we have seen the Dollar test fresh highs against most of its peers as the world grapples with the chaos of the pandemic. We saw a massive uptake in the Greenback as investors ran to safety. We consequently saw Dollar liquidity in the markets almost dry up completely. These factors helped support the Dollar. During this period, the U.S Dollar DXY index (DXY index) (a measure of the of the value of the U.S. Dollar relative to a basket of foreign currency) surged to 103. The DXY index which has been trading within a narrow range has since coming off its highs and is currently punching below key support levels. Since March we have started seeing breakouts in the DXY which have indicated that the 93 – 94 level is in sight. This could be a precursor to what may be a significant multi-year decline in the Dollar. See Figure 1.


As we start seeing more pronounced breakdowns in the Dollar, especially versus emerging market currencies, it will show that the broadly softer financial conditions that have been created in the markets are leading to increased global growth.

So, what is driving the Dollar lower? There are a few interrelated factors to consider when answering this question. The first factor to consider is that economic momentum is higher outside of the U.S than within the U.S. There were many non-U.S. economies (particularly in the East) that were hit by COVID-19 earlier than the U.S. Many of these economies are now well into their reopening phases, whereas the U.S continues to see staggering infection rates which hamper economic activity. Evidence of this hardship is seen in the U.S. GDP print for the second quarter of 2020. On a quarter-overquarter basis, the U.S. economy shrank by 32.9% in the second quarter. This is the deepest decline in output since the government started keeping records in 1947. The drop in GDP was more than triple the previous all-time decline of 10% in the second quarter of 1958. The U.S economy had previously contracted at a 5.0% pace in the first quarter of the year. Adding to the pressure is the unemployment numbers in the U.S. Continuing Jobless Claims spiked up to 17 million in July highlighting the fact that those people who lost their jobs initially have failed to find a new ones. This is worrisome for an economy with a historically tight labour market. The second factor underpinning our view on the Dollar is that money velocity (the speed of capital flows) is rising faster outside the U.S than inside the U.S. See Figure 2.

This suggests that confidence, both that of households and businesses, is increasing faster in non-U.S markets. Confidence is important for any economy in order to drive capital expenditure and allow pent up demand to be transformed into actual purchases and sales. There was a significant move towards a European fiscal union this month as E.U leaders agreed upon an additional EUR 750 billion corona virus recovery plan which forms part of a EUR 1.8 trillion spending package. This agreement marked a historical moment for the union, not only due to the size of the package but due to the process revealing preferences for Eu

ro membership. For over two decades, the standard dilemma plaguing the Euro area was that a centralized monetary policy was not a solution for desynchronized business cycles. The lack of fiscal transfers between member nations amplified this problem. Now that Italian and Spanish bond yields are aligning with other members’ yields, liquidity is flowing to where it is most needed. This has reduced the risk of a Eurozone break up. As a relatively closed economy, the U.S has a higher services component in their GDP. However, the service sector has been impacted harder by the pandemic due to social distancing measures that will likely remain in place for some time. See Figure 3.

This is important when considering growth prospects for the U.S relative to the rest of the world. As a countercyclical currency the Dollar tends to appreciate when U.S growth is higher relative to the rest of the world. The opposite holds true and therefore a prolonged recovery in the services sector within the U.S. raises the prospect that countries geared more towards manufacturing, such as Europe, Japan and China, could experience better growth. Over the past while, there has been a concerted effort by both institutional investors and Central Banks to diversify out of Dollar assets. This is not only evident in the official Treasury International Capital (TIC) data that continues to show that foreign officials are selling U.S Treasuries but within the International Monetary Fund reserve data as well. A significant portion of these flows have gone out of U.S Treasuries and into gold, driven primarily by emerging market countries such as Russia and China. See Figure 4. This further points to the fact that the Dollar’s reign as reserve currency may one day come to an end.


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