The U.S. dollar to fall further

The U.S. dollar to fall further

The U.S. dollar has continued to weaken materially since its February-March safe-haven spike related to COVID-19 and spreading of global government shutdowns, consistent with our expectations (Chart of the week – A weaker U.S. dollar: big implications, June 5, 2020). While we fully acknowledge the difficulties and pitfalls of forecasting major currencies, we expect that the U.S. dollar will weaken further.

When considering the U.S. dollar, we are reminded of a famous quote of Former Federal Reserve Chairman Alan Greenspan, who is noted for his history of thorough and wise forecasting: “forecasting exchange rates for major currencies is as accurate as forecasting the outcome of a flip of a coin.” This statement by the world’s leading central banker drew the ire of foreign exchange strategists who are paid to forecast foreign exchange, but nods of acknowledgement from honest economists and market participants.

We also acknowledge that models that attempt to forecast foreign exchange are unreliable, and key macroeconomic variables frequently used to forecast currencies have a history of not holding up over time. Nevertheless, several macroeconomic and policy factors are in place that are likely to push the dollar lower. We will not forecast a point estimate for the U.S. dollar; history tells us clearly that doing so provides no value-add.

A brief recap of recent long trends in the U.S. dollar

Historically, the U.S. dollar and other major currencies have moved in long waves, as shown in Chart 1. Accordingly, now it is appropriate to assess whether the recent weakness in the dollar is establishing a new trend, or is just temporary, and what factors may support that trend. While we do anticipate further weakness, we disregard any suggestions that the dollar will lose its reserve currency status as uninstructive commentary by negative seekers.

Ignoring the short-term fluctuations that are so difficult to forecast, there have been distinct long moves in the U.S. dollar versus other major currencies. Key macroeconomic factors underlie each long trend, and each long trend provides insights into the current situation. (For simplicity, we do not consider emerging market currencies in this assessment.) The dollar weakness in the 1970s (and sharp fall late in the decade) reflected higher inflation as well asmisguided macroeconomic policies and their adverse consequences on economic performance. In the first half of the 1980s, the dollar soared, driven by the dramatic decline in inflation and inflationary expectations and the Reagan Administration’s pro-growth tax policies that raised expected rates of return on dollar-denominated assets. The collapse in the dollar beginning in February 1985 was driven by the reversal of its over-bought position and paring back of some pro-growth policies, the U.S.’s high budget deficits and associated concerns about the high current account deficit, and the reinstitution of exchange rate market interventions that added uncertainty and contributed to the October 1987 stock market collapse. Higher inflation during 1987-1990 also contributed to a weak dollar.

The sustained and mounting strength of the dollar in the second half of the 1990s evolved out of the Fed’s successful preemptive anti-inflationary rate hikes in 1994-1995 that lowered inflationary expectations and engineered an economic soft landing. The dollar’s subsequent significant strengthening reflected the booming U.S. economy and stock market and high expectations about the U.S.-led high-tech boom. The dollar began depreciating in early 2002 as the Fed kept rates below inflation while the Euro surged as European economic performance advanced, consolidating confidence in the EU. During this period, global capital flows were characterized by large and mounting capital inflows into the U.S. from rapidly growing (and high-saving) China, and growing financial imbalances. The dollar continued to depreciate between 2005-2007, even as the Fed continued raising rates, as the U.S. debt-financed housing bubble began showing signs of financial stress and inflation rose.

This weak dollar trend abruptly ended as it became a safe haven from the risky turmoil of the 2008-2009 financial crisis. Following this spike, the dollar weakened during the subsequent soft U.S. economic recovery, depressed by the Fed’s zero interest rate policy and large-scale asset purchases that dramatically expanded the Fed’s balance sheet. In mid-2011, initiated by the intensifying European financial crisis, the dollar began a prolonged period of appreciation that extended through 2016, followed by mild depreciation. During this period, Europe faced several financial crises and recessionary economic conditions, and reliance on the ECB as the financial backstop for a fragile union (Charts 2 and 3). During this period, Asian nations had a sizable impact on foreign exchange. China was implementing its weak yuan policy as part of its mercantilist policies (Chart 4), while the Japanese Yen depreciated significantly as part of Prime Minster Abe’s reflation and pro-growth strategy beginning in late 2012 (Chart 5). Also, the dollar spiked significantly in the second half of 2014, as Europe faced intense financial strains while the Fed successfully tapered its large-scale asset purchases. The distinct economic weakness in China and global industrial slump, aggravated by the Trump Administration’s disruptive tariff war with China and increasing global tensions, lifted the dollar in 2019 following weakness in 2017-2018.

Several themes have tended to dominate these U.S. dollar trends. First, the dollar is clearly a safe haven and around crises, it always appreciates. Second, while some macroeconomic variables—like purchasing power parity, current account imbalances, and interest rate and inflation differentials—are not reliable predictors of foreign exchange, economic policymaking and overall performance, and how they influence expected risk-adjusted rates of return on U.S. dollar-denominated assets relative to expected returns on assets denominated in other currencies are consistently important in influencing trends in the dollar. Third, differences in central bank monetary policies, and particularly since the financial crisis of 2008-2009, their balance sheets and forward guidance, seem to be important predictors of advanced currencies.

Recent U.S. dollar behavior

In February and March of 2020, the dollar spiked as global portfolio managers sought a safe haven from the risks posed by the expected negative impacts of the rapidly spreading pandemic and government shutdowns and disorderly financial markets. Since late May, the dollar has weakened. Besides the declining demand for the safe haven dollar as the crisis has ebbed, three factors seem to underlie this trend. First, the spreading of the incidence of COVID-19 to many U.S. western and southern states has delayed the reopening of economic activities, creating weakness in the U.S. economy relative to Europe’s and other nations.

Second, the Fed’s monetary policies have been ultra-easy, particularly its aggressive asset purchases, which have ballooned its balance sheet relative to the balance sheets of the ECB, BoE, or BoJ (Chart 6). Moreover, the Fed has been more strident in its forward guidance that it will maintain an ultra-easy monetary policy. Third, the EU’s enactment of a sizable unified fiscal package has created excitement that it will reinvigorate European economic performance (EU: A big deal, Berenberg, July 21, 2020). This fiscal package promises to end a period of macroeconomic policy floundering, and is perceived to be a step forward in addressing the financial needs and fiscal policies of the EU’s weaker performers, particularly Italy. It also opens the door to larger EU unified debt-financed spending initiatives.

The outlook

To a certain extent, major foreign exchange rates are driven as much by the popular narrative as by any specific economic or financial data or trend. Popular narratives tend to generate momentum trading and historically have contributed to overshooting. Currently, the narrative is supporting a weaker U.S. dollar, and the thrust of real data and economic policies are consistent with these themes. On the horizon is a potential regime shift in the U.S. government economic policies that would contribute to further dollar weakness.

While the U.S. economic collapse in the first half of 2020 was smaller in magnitude than the declines in Europe or the UK, following a significant rebound in May and June, high-frequency data suggest that the U.S. recovery has clearly flattened (US: Strong rebound in goods consumption, but services consumption and labor markets remain depressed, August 5, 2020). This has drawn attention to the U.S. government’s general fumbling in dealing with the pandemic. At the same time, Europe’s economy has largely reopened, facilitating faster recovery. The EU fiscal package, following extended debate and differences, is lifting enthusiasm for European economic performance. While a follow-up U.S. fiscal income support package will be enacted very soon, it is widely acknowledged that the pace of economic recovery depends primarily on the pandemic-related health and confidence issue.

On the monetary policy front, while the Fed has slowed its aggressive asset purchases, it will maintain its ultra-easy policies. This was underlined by the Fed’s Board of Governor’s announcement that it will extend its emergency lending facilities through December 31 from September 30. While the Fed has not publicly revealed its new strategy on inflation, it has indicated clearly that it would allow inflation above its 2% longer-run target. If the Fed were to tie its QE to a 2% inflation target under current circumstances, as some now suggest, it would be a fairly explicit lower dollar policy.

As the current wave of the pandemic subsides, economic activity restarts, and the U.S. economy recovery resumes, expectations of more aggressive monetary easing and downward pressures on the dollar may abate.

Perhaps the largest risk to the dollar is the shift in economic policies that may be implemented under a Biden Administration. These policies are well intended but would lower potential GDP and dampen risk-adjusted expected rates of return on capital investments in dollar-denominated assets. In his official Presidential campaign website, Biden proposes significantly higher taxes and spending, and more regulations skewed against businesses and favoring labor, along with liberalized immigration policies (US presidential candidates’ economic platforms, February 27, 2020, and Joe Biden’s campaign platform).

Among the spending proposals, Biden’s New Green Deal proposes $2 trillion in new spending on “green infrastructure” over a four-year period, with 40% of the spending allocated to urban renewal of disadvantaged communities that have been harmed by the unhealthy environment (Joe Biden’s clean energy plan). The sizable increases in government purchases and job and income support to disadvantaged communities would add to aggregate demand and GDP. Biden’s proposal to liberalize immigration policies from the Trump Administration’s obstructionist policies would also add to economic activity.

Biden’s proposed significant increases in tax burdens would fall entirely on capital and high income and wealth individuals (US presidential candidates’ economic platforms, February 27, 2020, and Joe Biden’s campaign platform). This would be decidedly negative for expected after-tax rates of return on investment and business capital spending. For business taxes the proposals include: raising the corporate rate to 28% from 21%; eliminating the 20% rate cut for privately owned businesses; a minimum 15% tax on “book income” (implying a 15% minimum effective tax rate); and a minimum 21% tax on all overseas income in each country where the income is earned. For individual taxes, the proposals include: raising the top marginal rate back to 39.6%; taxing all capital gains as ordinary income (with the current “surtax,” for higher-income households, the rate on capital gains would be 42.4%, up from 32.4%); a 0.4 percentage point increase in payroll taxes on all wages for all workers, and an elimination of the taxable maximum wage caps on the OASI and DI portions of payroll taxes for higher-income individuals; and for estates, lowering the tax exclusion level and eliminating the step-up in basis at death.

Biden proposes an expansive regulatory agenda for labor, the environment, oil/shale drilling, and other industries including big social media firms. These policies may provide positive feedback regarding workers’ standards of living, if implemented as proposed, but they would raise business operating costs and add uncertainty that would harm expansion plans, both in terms of capital spending and hiring.

If a Biden Administration is accompanied by split power in Congress, with Democrats controlling the House and Republicans controlling the Senate, these tax and spending proposals would be tempered. However, as highlighted by the Obama and Trump Administrations, the ability of the President to circumvent the Congress and implement an economic agenda—on both domestic and international issues—through regulations and executive orders is significant and expansive. In this regard, evidence shows that business confidence and capital spending seems more sensitive to a burdensome regulatory environment than to higher taxes.

At this point, assessing the impact on the U.S. dollar is speculative. A Biden victory may elicit a relief rally, as global portfolio managers welcome a Biden Presidency that re-establishes friendly alliances with friendly nations and re-engages in the established international organizations that President Trump eschewed. However, history has shown the power of the economic policies that directly impact expected returns to capital. Obviously, a moderate version of the Biden economic agenda would have a moderate impact on financial markets and the U.S. dollar. On the other hand, financial market and dollar responses to the more aggressive policy agenda as favored by progressives and hard-left influences on Biden would be sizable.

Chart 1:

Chart 2:

Chart 3:

Chart 4:

Chart 5:

Chart 6: Major central banks balance sheets

Sources: Federal Reserve Board, Bank of Japan, European Central Bank, Bank of England,

and Berenberg Capital Markets

Mickey Levy, [email protected]

Member FINRA & SIPC
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