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Doubting the Dollar?

November 2, 2020 By Jeremy Jones, CFA

By Krakenimages.com @ Shutterstock.com

At the Financial Times, Michael Mackenzie explains the long term forces stacking up against the dollar. He writes:

With alarm bells ringing across financial markets in recent days, the US dollar has found its footing, reflecting its haven status whenever equities and investor sentiment take a knock. But that may prove fleeting given the longer term forces stacking up against the world’s reserve currency. Since climbing to its best level since 2002 in the wake of the pandemic earlier this year, the Federal Reserve’s trade-weighted dollar index has been pressured by a combination of rising trade and budget deficits, alongside expectations that ultra-low US interest rates are set for an extended stay. Despite rising this week, as global equities headed for their biggest weekly fall since the March turmoil, the dollar has still declined by 9 per cent from its peak in that month.

A weaker US currency acts like a safety valve within a global financial system that is heavily reliant on dollar-denominated debt and trading flows, particularly for emerging market economies. A sliding dollar also supports US business activity when interest rates are anchored near zero.

Renewed dollar weakness may well follow given the challenges facing the US economy, even in the wake of its record rebound in growth in the third quarter. Some economists believe a return to pre-pandemic US output does not beckon until late 2021. With rising coronavirus cases hitting an embattled service sector and employment prospects, the urgency of additional stimulus looms in the wake of next week’s US Presidential and Congressional elections.

“Regardless of the election outcome, the dollar has entered a cycle of relative decline,” observes Marc Chandler, chief strategist at Bannockburn Global Forex. “The old meme of twin deficits is coming back. The dollar becomes a shock absorber for the economy by weakening.”

The pandemic has already prompted a sharp deterioration in the US trade deficit in goods and services this year, according to official data. As for government spending, the Congressional Budget Office projects a $3.3tn budget deficit for 2020, constituting 16 per cent of gross domestic product and the largest amount of borrowing since 1945. For the 2021 financial year, the CBO expects the deficit to be a still eye-watering 8.6 per cent of GDP.

Rising deficits have so far failed to push long dated US interest rates significantly higher. This reflects expectations of a long recovery process for the US economy and jobs, as well as a Federal Reserve willing to expand its balance sheet and buy a lot more Treasury debt.

Expanding the balance sheet of the US central bank may take on greater urgency given an important aspect of the global pandemic, a rebounding Chinese economy and its currency.

Read more here.

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Jeremy Jones, CFA
Jeremy Jones, CFA, CFP® is the Director of Research at Young Research & Publishing Inc., and the Chief Investment Officer at Richard C. Young & Co., Ltd. Richard C. Young & Co., Ltd. was ranked #5 in CNBC's 2021 Financial Advisor Top 100. Jeremy is also a contributing editor of youngresearch.com.
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