The dollar is the world’s reserve currency and the most traded currency in global currency markets. At the same time, central banks across the globe hold it to maintain confidence in their own currency. Commodities are traded in US dollars, and many countries, especially in emerging markets, continue to peg their currencies to the greenback. These countries even issue their debt in dollars to pay a more attractive interest rate.
International investors are also heavily exposed to US equities as they sought to take advantage of the longest bull market in history by buying superior US companies, particularly in the technology sector. All these are good enough reasons to look at what is behind the dollar’s slide in recent months and how it affects the various stakeholders.
The dollar index, which tracks the greenback against a basket of the world’s most relevant currencies, has at one point fallen by almost 10 per cent since touching a three-and-a-half year high in March. This follows nearly a decade-long bull market that saw it appreciate by over 40 per cent.
Some of this sell-off may have to do with the fact that the dollar shot up so much at the outset of the crisis, as people saw the dollar as a safe haven. However, as the world’s focus has gradually shifted back to fundamentals, the dollar has rapidly slumped to a two-year low.
With the benefit of hindsight, we look to explain this sudden change of fortunes in the value of the dollar to seek to understand whether this is potentially a short-term blip or whether it could have longer-term implications.
First of all, the Federal Reserve’s response to the drop in economic growth resulting from the COVID-19 crisis has significantly narrowed the gap between US interest rates and those in other major countries. Before the Fed pivoted to a zero-interest-rate policy in March, US short-term yields were over 200 basis points higher than policy rates in Europe. While US rates are still higher today, the gap has narrowed substantially and currently stands at around 60 basis points.
Meanwhile, Fed chairman Jerome Powell left no doubt that the US central bank would do whatever it takes to support the economy throughout the economic impact of the coronavirus disease.
This was recently reinforced by the announcement of a new policy of average interest rate targeting that would allow the Fed to keep interest rates at zero, even if inflation temporarily rises above its two per cent target. Powell also appealed to lawmakers to continue with fiscal stimulus, because there is only so much that monetary policy can achieve.
More recently, the US’s growth prospects have slowed while inflation expectations have risen, which has sent real interest rates (adjusted for inflation) down in the US – another factor making the dollar less attractive to hold.
In addition to shifting to a zero-rate policy, the Fed also sharply increased access to US dollars through its swap facilities – liquidity arrangements − with other central banks until March 2021, increasing the supply of dollars in the global economy and enabling greater access to dollars to a wide set of economies at a lower cost.
A weaker dollar can help make US exports more affordable and boost economic growth
The initial slow US response to the coronavirus crisis has altered expectations about economic growth relative to major country peers. Before the latest resurgence in cases in Europe, the market perception was that the outbreaks in Europe and China had peaked, while in the US cases were still rising. Consequently, the US economy was deemed likely to take longer to recover, with higher unemployment and weaker consumer spending. Finally, US fiscal policy has been more fragmented than the response in Europe or Asia.
At the moment, US lawmakers remain gridlocked in controversy between the Democrats’ recently-revised proposal for a $2.4 trillion worth of fiscal stimulus and the Republicans’ latest proposal for a $1.5 trillion package, which is much smaller. Resolution of the dispute as soon as possible is essential, because benefits from the previous package expired at the end of July.
At the same time, the European Union’s recovery fund marks a step towards greater mutualisation of debt – a factor that can reduce the perception of risk around the euro. Recent purchasing managers index (PMI) data suggest that the US economic rebound is levelling off while growth is rising in most other regions.
Rising tensions between the US and China, as well as the upcoming presidential election, also make the outlook for the US less certain. With less clarity about the direction of policy or its implications for the economy and regulations, foreign investors may begin to shy away from US investments. While the dollar is still a safe-haven currency in times of global turmoil, in the absence of a crisis, the outlook for other countries looks more predictable.
Rising US budget deficits along with easier monetary policy could weigh on the dollar. Because the US is a net debtor nation, a rising budget deficit needs to be financed with foreign investment.
Historically, a rising budget deficit has often been a leading indicator of dollar weakness. Financing ever-rising deficits over the next decade with foreign capital could create a supply/demand imbalance. In the absence of higher interest rates, a weaker dollar would make US investments more attractive to foreign investors.
A weaker dollar should be positive for the global economy, especially commodity exporting and emerging-market countries. Because many global goods are traded in US dollars, a lower dollar makes goods more affordable for foreign buyers, benefitting commodity exports. It also reduces the cost of servicing US-dollar denominated debt.
Emerging market borrowers have splurged on dollar-denominated debt over the past decade, more than doubling the amount outstanding. Domestically, a weaker dollar can help make US exports more affordable and boost economic growth while raising inflation by pushing up the cost of imported goods.
Where we go from here is difficult to predict. As we have seen over the past few days (with the dollar staging a significant rebound), a lot will depend on how the pandemic spreads in the US as opposed to other geographies. Equally important will be the amount of future US monetary and fiscal stimulus in comparison to other parts of the world, the yield on the 10-year Treasury and, of course, the outcome of the US presidential election later this year.
One thing is certain though, irrespective of all the variables above: the dollar remains the global reserve currency, because there is simply no alternative.
For more information, visit www.cc.com.mt. The information, views and opinions in this article are provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.
Stephen Borg, Head of Wealth and Fund Management at Calamatta Cuschieri