There are many reasons to expect a weaker U.S. dollar next year and perhaps longer, but none more important than the Federal Reserve’s new political stance.
The US dollar concentrated briefly in March due to its role as a safe haven in investment portfolios. Since then, it has fallen about 12% relative to a trade-weighted currency basket, as the United States turned out to be even more affected by the coronavirus pandemic than most major economies.
As vaccines are deployed and the global economy recedes, this trade will not necessarily work the other way around. Rather, the currencies of countries that export commodities and manufactured goods are likely to continue to strengthen against the dollar, as would be seen in a typical global recovery. Some Asian exporters are already quietly intervening to limit the rise of their currencies.
But this time, the reasons for expecting a weaker dollar are even deeper. For several years before the pandemic, US interest rates on both the long and short ends of the yield curve were substantially higher than in Europe and Japan, a major source of strength for the pandemic. American currency. This premium has largely disappeared as the Fed cut short-term rates to almost zero and launched a new round of asset purchases. The yield on ten-year US Treasury bills has fallen from almost 2% at the beginning of the year to around 0.93% today.
Of course, it is still well above the yields of 0.02% and the minus 0.58% of Japanese and German government ten-year bonds, respectively. But in fact, real yields in the US are lower as a result of inflation, says Simona Gambarini, market economist at Capital Economics. In the United States, the basic consumer price index was 1.6% higher than the year before November. This compares with slight deflation in Japan and the euro area.
This difference in real rates is unlikely to be reduced any time soon. After all, the Fed pledged in August to let inflation exceed its 2% target for an extended period and not to respond to falling unemployment with preventive rate hikes. Meanwhile, the same central banks around the world continue to point to inflation rates around 2%, although they do not reach this level.
If markets take the Fed’s word, they won’t offer the dollar, as they normally could in response to solid U.S. inflation or growth data. That’s why TS Lombard economist Steven Blitz sees the new framework as an effective end to the U.S. government’s traditional “strong dollar” policy.
Consider, for example, the possible market reaction to a large stimulus package at the start of the Biden administration. Large doses of deficit spending are usually considered negative in dollars because they mean the U.S. will have to import more foreign savings. But the stimulus could be considered positive in dollars if it successfully increases U.S. growth. This time, however, the Fed essentially promised not to raise rates preventively in response to positive economic news, so a large stimulus package is likely to be negative for the dollar.
None of this should be bad news for investors. Because most assets are priced in dollars, a weaker dollar often means higher prices on assets, from stocks to commodities and emerging market bonds. Investors with a concentrated net worth in dollars should make sure they diversify, for example, by not hedging the foreign exchange exposure of their foreign holdings, says Brian Rose, senior economist at UBS Wealth Management .
The perennial and strong dollar may be a thing of the past. Investors are unlikely to miss it.
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