Following an appreciation cycle that has spanned nearly a decade, the dominance of the U.S. dollar looks to have been upended by the COVID-19 pandemic, or so the conventional wisdom goes. We believe the outlook is far more nuanced and region-contingent, as evidenced by the dollar’s divergent performance versus advanced (G-10) and emerging market (EM) currencies in the last few months.
In our view, the dollar faces an uphill battle from here. Early on in the pandemic, the dollar appreciated consistent with its historical role as the ultimate safe-haven currency.1 But we believe an unprecedented degree of fiscal support, the Federal Reserve’s expected commitment to make up for past inflation target undershoots, and the United States’ uneven recovery are likely to impart a depreciation bias to the dollar in all but the most extreme cyclical scenarios.
ACCOMMODATIVE MONETARY POLICY HAS DEPRESSED YIELDS, VALUE OF U.S. DOLLAR
The Fed’s aggressive monetary policy response has eroded the dollar’s yield advantage built up over a multiyear cycle of rate hikes. In our view, this advantage is unlikely to be restored anytime soon. We believe that Fed policy will remain accommodative for as long as it takes to bring inflation back to target, “on average.” Given our expectation that full employment does not return before mid-2024, this would set the Fed on course for a multiyear period of very low policy rates and asset purchases.
In the event of a fresh negative shock to the global economy, low bond yields could weaken the U.S. dollar’s long-standing status as a safe asset. At the same time, we think the Fed’s revealed preference to mitigate dollar funding pressures via dollar swap lines with major central banks should limit the extent to which the dollar rallies in periods of stress.
DOLLAR’S DOWNSIDE COULD BE LIMITED, BUMPY
On the flip side, we believe the unique nature of the pandemic shock will remain a constraining factor on how far and fast the dollar can fall. Previous depreciation cycles have seen the real trade-weighted dollar fall some 15% to 20% relative to current levels.
Even then, the dollar would still only be marginally undervalued based on our estimates. Historically, the dollar’s decline has been most rapid out of deep recessions, and 8% to 10% annual depreciations have taken place on five occasions between 2003 and 2018.
Nonetheless, the unique circumstances surrounding this cycle suggest that the path lower will be bumpy, although a decline to previous lows looks unlikely.
An analysis of past episodes of pandemics suggests low predictability around how COVID-19 spreads until an effective medical intervention is available. As long as virus-related uncertainty exists, we would expect the drag on global growth to constrain the extent and breadth of any USD decline. This is particularly relevant for some EM currencies, which now account for roughly half of the trade-weighted dollar and where scarring effects from the crisis look likely to be pronounced and persistent.
SPEED, EXTENT OF DOLLAR DEPRECIATION CONTINGENT ON ALTERNATIVE CURRENCIES
The relative strength of alternative currencies will likely hinge on a number of economic variables:
Euro: Any broad-based decline in the dollar is highly likely to lead to appreciation of the euro, the second-largest currency bloc in the world. We believe that, coupled with the European Central Bank’s robust Pandemic Emergency Purchase Program, the recent European Council agreement on the EU Recovery Fund increases the euro’s attractiveness as an alternative to the dollar. In years past, markets have repeatedly experienced stress in European bond markets as investor fears of euro area breakup risks increased. The EU Recovery Fund is expected to create a large pool of common EU sovereign debt and allow for intra-regional fiscal transfers that should reduce breakup risk in the face of asymmetric shocks to various countries.
Yen: The Japanese yen offers another potential alternative. Owing to Japan’s status as the world’s largest external creditor, the yen tends to weaken in periods of strong economic growth and improving risk appetite. However, compared with other currencies, the yen is also highly sensitive to changes in relative U.S. real yields. The current decline in U.S. real yields to record lows has dominated the yen’s risk-on characteristics, allowing it to participate in the dollar’s broad sell-off. We believe these trends will continue if the Fed keeps rates low long enough and commits to some inflation overshoot.
Other developed countries: Developed market currencies like those of Australia, Canada, and Norway are also likely to benefit from dollar weakness. So far, all of these countries have had relative success in managing the spread of COVID-19. These economies are well placed to participate in a recovery of global growth as demand for their commodity exports improves.
While their central banks have cut policy rates aggressively, they have refrained from cutting rates into negative territory. Additionally, all of these economies have excellent conditions in which to expand fiscal policy and stimulate growth locally.
Emerging markets: Within the EM universe, country selection is likely to be more important given the unique challenges and stresses created by COVID-19. Effective virus containment (and in turn, the speed with which borders can reopen) and the need to fall back on extremely loose monetary policies to increase fiscal capacity will be critical variables in determining winners and losers.
Following the region’s success in containing the pandemic, we would expect the North Asian complex of currencies, led by the Chinese yuan (renminbi) and Korean won, to benefit from economic recovery and the return of a robust tech export cycle.
The trade-weighted yuan is near its weakest levels since the currency was floated in 2005, with some risk premium built in for the ongoing U.S.–China trade conflict.
Despite the benefits imparted to all economies from accommodative Fed policy, we anticipate the full-fledged participation of higher-beta emerging market currencies in Latin America, Europe, and Africa to take longer, given less effective control over the virus, more limited fiscal policy buffers, and already-weak starting conditions. We eventually expect some of the high beta EM currencies to be part of the dollar depreciation story, but only after a broadening global recovery and, likely, a successful vaccine.
VACCINE UNLIKELY TO BE A PANACEA
The bottom line: We believe the dollar is set to decline further. The extreme tails in which the dollar performs best have not disappeared but have arguably been flattened due to aggressive fiscal and monetary responses around the world.
The speed with which a successful COVID-19 vaccine arrives will also have some bearing on how fast the dollar sinks from here. Our baseline is that the earlier the vaccine, the better it is or global growth. Somewhat perversely, this could hasten the dollar’s fall from grace.
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