There are many reasons to expect a weaker US dollar next year and perhaps longer, but no more important than the new policy stance of the Federal Reserve.
The US dollar recovered briefly in March due to its port role in investment portfolios. Since then, it has fallen about 12% against a trade-weighted basket of currencies as the US proved to have been hit even harder by the coronavirus pandemic than most major economies.
As vaccines roll out and the global economy returns, this trade will not necessarily reverse. The currencies of countries that export commodities and industrial goods are likely to continue to appreciate more strongly against the dollar, as evidenced by a typical global recovery. Some Asian exporters are already quietly intervening to limit the rise in their currency.
But this time, the reasons for expecting a weaker dollar run even deeper. Before the pandemic, US interest rates on both the long and short ends of the yield curve were significantly higher than in Europe and Japan for a number of years – a major source of strength for the US currency. However, that premium has largely disappeared when the Fed cut short-term interest rates to near zero and launched another round of asset purchases. The yield on 10-year US Treasury bonds has fallen from nearly 2% at the start of the year to about 0.93% now.
Admittedly, that’s still a lot higher than the 0.02% and minus 0.58% interest on 10-year Japanese and German government bonds, respectively. But real returns in the US are actually lower on an inflation-adjusted basis, emphasizes Capital Economics market economist Simona Gambarini. In the US, the core consumer price index was 1.6% higher than a year earlier in November. This is comparable to a slight deflation in Japan and the eurozone.
This difference in real interest rates is unlikely to narrow any time soon. After all, in August, the Fed promised to keep inflation above the 2% target for a longer period and not to react preventively to falling unemployment. Meanwhile, comparable central banks around the world continue to aim for inflation rates of around 2%, while lagging far behind.
If markets take the Fed at its word, they won’t raise the dollar as they normally would in response to robust US inflation or growth data. That’s why TS Lombard economist Steven Blitz calls the new framework an effective end to the traditional. ” strong dollar “policy of the US government.
Consider, for example, the likely market reaction to a major stimulus package early in the Biden government. High doses of deficit spending are typically seen as negative in the dollar because they mean the US will have to import more foreign savings. But stimulus packages can be viewed as dollar-positive if they successfully stimulate US growth. This time, however, the Fed has essentially pledged not to preemptively lift interest rates in response to positive economic news, so a major stimulus package is likely to be unequivocally negative for the dollar.
This doesn’t have to be bad news for investors. Since most assets are priced in dollars, a weaker dollar often means higher asset prices for everything from stocks to commodities to emerging market bonds. Investors whose net assets are concentrated in dollars should make sure that they are diversified, for example by not hedging the currency exposure on their foreign equity holdings, said Brian Rose, Senior Economist, Americas at UBS Wealth Management.
The perpetually strong dollar may be a thing of the past. Investors probably won’t miss it.
Write to Aaron Back at [email protected]
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