There are many reasons to expect a weaker dollar next year and perhaps for longer, but none more important than the Federal Reserve’s new political stance.
The US dollar rose briefly in March due to its safe haven role in investment portfolios. Since then, it has fallen by about 12% compared to a basket of trade-weighted currencies, as the United States ended up being hit even more by the coronavirus pandemic than most major economies.
As vaccines are launched and the global economy recovers, this trade will not necessarily work the other way around. Instead, the currencies of countries that export commodities and manufactured products are likely to continue to strengthen against the dollar, as would be seen in a typical global recovery. Some Asian exporters are already discreetly intervening to limit the rise in their currencies.
But this time, the reasons for expecting a weaker dollar are even more profound. For several years before the pandemic, US interest rates at the long and short ends of the interest curve were substantially higher than in Europe and Japan – an important source of strength for the American currency. That premium practically disappeared, however, as the Fed reduced short-term rates to almost zero and launched a new round of asset purchases. Yield on 10-year US Treasury bills has dropped from almost 2% at the beginning of the year to about 0.93% now.
Granted, this is still much higher than the 0.02% and -0.58% yields on 10-year Japanese and German government bonds, respectively. But real yields in the US are actually lower on an inflation-adjusted basis, points out market economist Simona Gambarini of Capital Economics. In the USA, the core consumer price index was 1.6% higher than at the beginning of November. This compares to mild deflation in Japan and the eurozone.
This difference in real rates is unlikely to diminish any time soon. After all, the Fed pledged in August to let inflation exceed its 2% target for a long time and not respond to falling unemployment with preventive rate hikes. Meanwhile, peer central banks around the world continue to target inflation rates of around 2%, although they fall well short of that.
If markets take the Fed’s word, they will not raise the dollar as they normally would in response to robust inflation or US growth data. That’s why TS Lombard economist Steven Blitz calls the new structure an effective end to the US government’s traditional “strong dollar” policy.
Consider, for example, the market’s likely reaction to a large stimulus package at the start of the Biden government. Large doses of deficit spending are usually seen as negative for the dollar because they mean that the US will have to import more foreign savings. But the stimulus can be seen as positive for the dollar if it successfully boosts US growth. This time, however, the Fed has essentially pledged not to raise rates preemptively in response to positive economic news, so a large stimulus package is likely to be unmistakably negative for the dollar.
None of this needs to be bad news for investors. Since most assets are quoted in dollars, a weaker dollar generally means higher asset prices on everything from stocks to commodities and emerging market bonds. Investors whose equity is concentrated in dollars should make sure that they are diversified, for example, by not protecting the currency exposure of their holdings in foreign stocks, says Brian Rose, Senior Economist for the Americas at UBS Wealth Management.
The perennially strong dollar may be a thing of the past. Investors are unlikely to miss this.
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