The US dollar has been falling over the last couple of months, even against sterling which itself has weakened versus the Euro and the Yen. After US dollar strength through the peak of the pandemic, (which is typical given its safe haven status during periods of rising risk aversion such as a decline in the global economic outlook), it has recently fallen sharply such that Sterling is now flat versus the US dollar year to date. This is not a story of sterling strength, however. Concerns about the UKs muddled virus response and the lingering Brexit impasse have caused the pound to fall approximately 5.5% against the euro, 5% against the Japanese yen, and 6% versus the Swiss franc this year.
Not that the dollar is particularly weak, given it is trading well above its 10 year average, nevertheless, what are the possible reasons for such a sudden setback in the value of the ‘greenback’- 5% in trade weighted terms in July and the largest monthly fall in over a decade.
One might expect the US dollar to ease back slowly as the world grows in confidence and businesses take investment risks again but the drop in the dollar during the second half of July, at least, came alongside a small fall in stock markets upon the realisation that any recovery is not going to be ‘straight-lined’ as lockdown measures are re-imposed to tackle infection resurgence hot spots. So, in this respect, the currency behaved oddly and accordingly there must be other forces at work.
Firstly, any relative weakness could be due to the factors strengthening the other currency. The euro may well have benefitted in July given the signs European policymakers were getting their act together in producing and announcing the significant new stimulus package which has been well received. But this is not enough to justify the extent or sharpness of the weakening.
Another cause could be the extent of the massive money printing by the Federal Reserve combined with the deepening political dysfunction of the Trump administration and the deteriorating trade / strategic rivalry with China. All these factors could be involved in the dollar losing some of its shine, albeit there remains no credible alternative to the dollar as a reserve currency yet, with the renminbi suffering a setback in its mission to become one, following recent strains between China and the US.
A further, and perhaps not insignificant cause could be related to a big change in inflation expectations, as evidenced by the strong inflows into US Treasury Inflation Protected Securities (TIPS) over the period. As nominal yields remained static, real yields fell below 1% (for 10 year debt) for the first time since TIPS were first issued, making US treasuries less attractive than sovereign debt elsewhere, i.e. where inflation is expected to be more muted and where higher yields can be found. With this, there are concerns that the Federal Reserve might allow inflation to pick up and remain over target for a while before raising rates, as it potentially adopts a philosophy of treating its inflation target as an average over a period rather than a fixed point. This could have added further to the unattractiveness of US Treasuries.
So is the decline in the US dollar now over?
In the near term, as the withdrawal of emergency unemployment benefits weighs on the US economic recovery, further weakness could be on the cards. We are already starting to see a stalling of economic data and families losing their benefits could make August’s data even worse, particularly as the US Senate still seems far from reaching a deal on fiscal stimulus.
However, the selloff looks possibly overdone on plenty of measures and perhaps already takes this into account such that a bounce back is also possible in the short term. As with everything at the moment, it depends on the virus and our management of it. As we head towards winter in the northern hemisphere, fears are of an increase in infection rates and whilst now better prepared, further lockdowns and thus reductions in economic activity look on the cards. With the US exchanges fostering companies that weather well and are even advantaged in a ‘stay at home’ world, and the fact that the dollar is still seen as a safe haven, we could see dollar strengthening in the short term at least, even if, over the longer term it will most likely weaken as US global influence wanes.