So far, this has been a volatile year for financial markets, and the currency markets have been no exception. The US dollar advanced nearly 9% in the first quarter before giving back almost two-thirds of its rally as of the middle of August. After declining nearly 5% at one point in the first quarter, the euro is now up 11% from its March lows. The Australian dollar fell 18% in the first quarter and has since rallied 25%. The Mexican peso fell 27% in the first three months and has since rallied 15%. Unlike developed market currencies, emerging market currencies, in general, have not yet recovered their losses. As far as what may drive the US dollar going forward, there are both shorter-term and longer-term factors to consider.
Before looking forward, it is important to understand the factors that influenced currencies, particularly the US dollar, in the first half. The dollar’s first quarter rally was driven by four factors. The first factor was the path through which the pandemic impacted the world. China was hit first, then South Korea, and their economies were the first to slow.
Next came Europe, notably Italy and Spain. Then, the pandemic spread to the US. In terms of sequencing, the US economy initially outperformed the rest of the world this year, and consequently, the dollar appreciated against most currencies as well.
The second factor that supported the dollar was the higher level of US interest rates compared to developed markets and even some emerging markets.
Third, the sharp flight to quality in March supported US dollar appreciation as investors focused on capital preservation in safe-haven Treasuries. Essentially, one of the safest currency markets in the world offered the highest interest rates in the world.
The fourth factor driving currencies was very specific to this environment — the pandemic was an extraordinary income shock that created severe financing stress. In comparison, the GFC in 2008 was largely a funding shock. The GFC centred on a problematic banking system and overleveraging.
This time, the challenge was not so much the availability of credit as it was the collapse of income — revenue disappeared overnight as the world went into lockdown during March and April. And, the impact was indiscriminate. Even high-quality companies with modest liabilities struggled to generate sufficient US dollar revenue to meet their debt obligations. As revenues disappeared, there was a desperate scramble to find US dollar financing to roll over existing obligations until revenue normalised.
Short-term supports for the dollar are dissipating
These factors driving the dollar have largely reversed. The pandemic stabilised in Asia and Europe, ahead of the US. Growth started recovering first in China and South Korea with a similar story in Europe. The US recovery has lagged those recoveries, and the particularly acute “second wave” in the US is amplifying the growth lag between the US and the rest of the world.
Secondly, the US Federal Reserve slashed interest rates to zero, so there is no longer an advantage to holding dollars relative to other markets. The Fed also pursued a large range of unconventional policies to expand the supply of money and credit for the economy. Measures of money supply have expanded rapidly — through the end of July, M1 grew 38% over the previous year, the strongest growth rate of money supply in 80 years. The sharp rally in gold and gold equities reflects this monetary development. The Fed has succeeded in not only reducing the price of money (interest rates) but has also succeeded in rapidly expanding the supply of money. Both factors are negative for the dollar.
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The flight to quality is also reversing as the pandemic stabilises and confidence returns. Lastly, the Fed went out of its way to alleviate dollar-funding pressures with the expansion of dollar-lending facilities through swap lines to foreign central banks. As the negative growth effects of the virus subside and the global economy recovers, the US dollar is likely to weaken further, particularly against the more growth-sensitive currencies of emerging markets.
The longer-term dollar story
Beyond the dollar’s cyclical path, its longer-term drivers are worth considering at this point. The current dollar bull market, which began in 2011, has been supported by two major factors. The first is growth leadership. US dominance in technology, notably in high-profile “soft” tech companies, has been a key reason for US growth outperformance.
While the rates of US growth and productivity growth have not been as strong as the economy experienced in the late 1990s and the technology boom during that decade, it is nevertheless the case that the US economy has notably outperformed the major regions around the world. For this reason, the Fed was the only major central bank to embark on a cycle of meaningful rate hikes from 2016 to 2018. The strength of the US economy was unmatched elsewhere, and other central banks were unable to pursue a similar scale of monetary tightening.
The second factor during this expansion has been the resilience of the US current account balance. Normally, when the US economy outperforms and the dollar appreciates, the external account deteriorates as the US imports more, reflecting stronger domestic income growth and cheaper foreign goods, and exports less, losing competitiveness from a stronger dollar. However, over the past decade, the US current account has remained stable at around –2% of GDP.
There are two factors behind this resilience. One, the US energy trade balance has improved significantly over the past decade, largely offsetting any deterioration in the goods trade balance. The material increase in energy production from shale gas and oil has allowed the US to “spend” this income without leading to a deterioration in the external balance.
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Two, the US net income balance is still closest to its highest surplus in history. That means the US received more income from its investments and loans abroad than it pays on its obligations to foreigners’ investments and loans.
In summary, we believe the current dollar bull market has been driven by stronger US growth, led by technology, and a more resilient external balance. However, the dollar story may be changing for other reasons.
The first longer-term theme that has turned negative for the US dollar is political. Policymakers have effectively crossed the Rubicon with respect to Modern Monetary Theory (MMT). Alongside a rapid expansion of the fiscal deficit, the Fed has commensurately expanded its balance sheet. Through the second quarter, US real personal income grew at its fastest pace ever.
If one was unaware that the US was experiencing its worst recession in nearly 100 years, income growth would have suggested the economy was booming. As the money supply chart above indicated, the Fed provided all the monies needed for the government to send out that support. However, MMT is a longer-term negative for the dollar.
Moreover, the current polling leader for the US presidential election, Joe Biden, is campaigning on a platform to raise corporate taxes. Just as the lowering of taxes boosted growth and the dollar in 2018, an increase in corporate taxes in 2021 will likely discourage capital inflows into the US, weakening the dollar.
Meanwhile, the political winds in Europe and China have moved in different directions. The eurozone has taken an important step toward fiscal union. Germany has finally gotten off the fence and recognised the need to help member states without conditionality, offering to assist the hard-hit countries of Southern Europe with grants and not just loans.
In the same way that New York and California taxes moved seamlessly through the federal government to help states ravaged by Hurricane Katrina, Europe has formalised a similar mechanism for the Covid-19 crisis. This is a pivotal change for Europe, a step toward fiscal unity, and a positive for the euro.
Meanwhile, Chinese authorities have taken a much more measured approach to using monetary policy to respond to the pandemic. China rapidly expanded money supply and credit following the GFC in 2008 and the commodity collapse in 2016. Both periods, however, led to a rapid increase in debt levels and misallocations of capital.
This time around, China has moved more carefully, and money supply and credit growth have accelerated more modestly. In relative terms, US monetary policy is far looser than Chinese monetary policy, a negative for the dollar.
The second factor that has turned negative for the dollar is the more structural impact of the virus on the US economy. While a variety of factors explain why some countries experienced more significant outbreaks than others, one common factor appears to be the size of the service sector.
This relationship makes sense considering the service sector relies on interactions between people, providing more scope for transmission — and the US has one of the largest service sectors in the world. Unlike any recession postWWII, the current recession is primarily a service sector recession. As the virus subsides in response to treatments, supplies, and ultimately a vaccine, the service sector will recover, and unemployment will decline.
However, the impact of the virus on the economy will last well beyond the development of a vaccine. We are learning through the corporate world to what extent employees can operate from home.
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We also are finding other ways for interacting, re-evaluating commercial real estate needs, and seeing restaurants operate differently. These changes and others like them mean there are service sector jobs that are just not coming back, and that should hurt the US more than economies that are more manufacturing heavy.
The US might have to contend with an elevated unemployment rate for longer until those individuals find different jobs and different training for different industries. That is a reason for the Fed to be somewhat easier relative to other central banks around the world, which should weigh on the dollar.
Weaker outlook for the dollar
In summary, we believe the dollar is likely to weaken further over the medium term. The movement toward MMT, the divergent political transitions in the US, Europe, and China, and most importantly, the prolonged structural adjustment still ahead for the US service sector are likely to weigh negatively on the dollar for some time.
Admittedly, the US current account has not shown the erosion in competitiveness that marked the 1980s and 1990s bear markets. Furthermore, US leadership in the technology sector remains robust. However, these factors are more likely to limit the degree of US dollar weakness than change the overall negative path for the dollar ahead.
Anujeet Sareen, CFA, is portfolio manager from Brandywine Global, a specialist investment manager of Franklin Templeton
