There are many reasons to expect a weaker US dollar next year, and perhaps longer, but nothing more important than the Federal Reserve’s new policy stance.
The US dollar rose sharply in March due to its refuge in investment portfolios. Since then, it has fallen by about 12% against a trade-weighted basket of currencies, as the US has been hit even harder by the coronavirus pandemic than most major economies.
As vaccines are rolled out and the world economy collapses, this trade will not necessarily go the other way around. On the contrary, currencies of countries exporting products and manufactured goods are likely to continue strengthening against the dollar, as evidenced by a typical global recovery. Some Asian exporters are already quietly intervening to curb the rise in their currencies.
But this time, reasons to expect a weaker dollar to rise even deeper. For several years before the pandemic, US interest rates at both the long and short ends of the yield curve were significantly higher than in Europe and Japan – a major source of strength for the US currency. However, the premium largely disappeared as the Fed lowered short-term rates to near zero and began a new round of asset purchases. Yields on U.S. Treasury notes for ten years have dropped from nearly 2% at the beginning of the year to about 0.93% so far.
Granted, this is still significantly higher than the yields on Japanese and German government bonds of 0.02% and minus 0.58%, respectively. But real yields in the US are actually lower on an inflation-adjusted basis, shows market economist Simona Gambarini of Capital Economics. In the US, the core consumer price index was 1.6% higher than a year earlier in November. This can be compared to slight deflation in Japan and the eurozone.
This gap in real rates is unlikely to narrow any time soon. After all, in August the Fed promised to keep inflation above its 2% target over a long period of time and not to respond to falling unemployment with preventive rate hikes. Meanwhile, peer-to-peer central banks around the world continue to target inflation rates of around 2%, while shooting well against them.
If markets put the Fed to its word, they will not offer the dollar as usual due to robust inflation or growth figures from the US. That’s why Steven Blitz, an economist at TS Lombard, called the new framework an effective end to traditional “strong dollar” policies of the US government.
Consider, for example, the likely market reaction to a large stimulus package early in the Biden administration. Large doses of deficit spending are usually considered dollar-negative because it means the US will have to import more foreign savings. But stimulus can be seen as dollar-positive if it successfully increases US growth. This time, however, the Fed has essentially promised not to raise rates for the time being in response to positive economic news, so a major stimulus package is likely to be unequivocally negative for the dollar.
None of this has to be bad news for investors. Since most assets are priced in dollars, a weaker dollar often means higher asset prices on everything from stocks to commodities to emerging market bonds. Investors whose net worth is concentrated in dollars should make sure they are diversified, for example by not hedging the currency exposure on their foreign equities, says Brian Rose, senior economist, America at UBS Wealth Management.
The eternally strong dollar may be a thing of the past. Investors are unlikely to miss it.
Write to Aaron Back by [email protected]
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