Dollar bears on wrong track

Depreciation fears were wrong in early 2021 and shouldn’t be overplayed now

At the start of the year, market consensus expected the dollar to drastically depreciate in 2021. So far, that has proved to be misguided. Some, including myself, questioned it at the time, suggesting that range trading might be more likely and warning against overplaying the narrative, even if there were grounds for dollar weakness.

The dollar strengthened between January and March on the back of stimulus and higher long-term rates. However, as longer US rates eased in April, the dollar depreciated. Building on this move and last week’s surprisingly weak April employment data, a new wave of rehashed arguments is pointing again to the dollar coming under major pressure. Just as earlier this year, these arguments shouldn’t be overplayed.

First, many foreign exchange participants focus heavily on the euro/dollar as the dominant currency pairing, shadowed by many other European currencies. The euro has fluctuated within a 4% range against the dollar this year. So has the dollar index (DXY), three-quarters of which consist of European currencies. But while the dollar is well down from its March peaks, it’s essentially flat for the year. Such movements should draw yawns from policy-makers, though traders may be more excited.

Second, many argue that Europe will quickly begin catching up with US growth and vaccination numbers in the second and third quarters of the year, which will buoy the euro. Some point to strong European equity flows into the US in the first quarter of this year but observe that the US stock market may be top-heavy and European shares will perform better during the recovery.

While plausible, these assertions need tempering. Short-term rates in the US and euro area will remain around their lower bounds for the foreseeable future. US longer-term rates picked up substantially in the first quarter but eased in April, notwithstanding fiscal stimulus. European longer-term rates – such as German bunds – have also risen, though remain negative.

With booming US growth expected in the second and third quarters of the year, a key question is whether US long-term rates will rise again. Many have predicted a 2% handle (if not higher) up from 1.6% on the 10-year Treasury by the end of the year. Higher US longer-term rates would support the dollar. However, if rates remain around current levels, that could validate the case for a weaker dollar.

Further, debates about the start of tapering could intensify in coming months. Many Federal Open Market Committee members and analysts are already questioning the Fed’s median dot plot, which points to an unchanged Fed funds rate until 2024.

Europe faces a period of prolonged monetary accommodation, more so than the US, despite ‘frugal’ Bundesbank views. European officials are not prepared to tolerate significant euro strengthening.

Third, arguments about US twin deficits are resurfacing. The current account deficit may surge towards 4% of gross domestic product this year, from the 2+% range it held over the past decade. For the second year in a row, the US fiscal deficit may be around 15% of GDP.

However, the US should be able to finance such deficits given the depth and attraction of its financial system. With long-term Treasury yields easing after the passage of President Joe Biden’s $1.9tn stimulus package and the dollar only slightly depreciating against other major currencies since then, difficulties are hardly evident. Any twin deficit problems in tapping into adequate finance could manifest in higher interest rates and/or a lower exchange rate. Higher interest rates could absorb the burden of attracting necessary flows.

Fourth, commentators argue that higher US rates will hurt emerging market currencies. If so, that contradicts the story of the dollar being under pressure. But here too, views should be modulated. It matters whether higher rates reflect stronger US growth or a surprise market development – the former being far less impactful on markets.

China and Mexico account for over half of the dollar’s emerging market trade-weighted index, which itself is just over half of the broad US trade-weighted dollar index.

Chinese authorities keep one eye on the renminbi/dollar exchange rate and another on general stability in their trade-weighted basket. The renminbi rose substantially in 2020 and is up slightly this year against the dollar. When the dollar falls against major currencies, the renminbi tends to rise against the dollar and vice versa. If the dollar is generally steady, one can expect the renminbi to remain broadly steady as well.

Other surplus Asian countries, which account for a considerable share in the US trade-weighted index, are keeping a close eye on China. The US Treasury may put pressure on them for appreciation. The Mexican peso weakened through mid-March but has since retraced. Though the peso is supported by Mexico’s restrained macroeconomic stance, the government’s policies are hardly conducive to attracting investment flows.

Predicting exchange rates is a hazardous undertaking, but currency factors do not point to major downward pressure on the dollar.

Mark Sobel is US Chairman of OMFIF.

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