There are many reasons for expecting a weaker U.S. dollar next year and possibly for a longer period of time, but none more important than the new Federal Reserve policy stance.
The U.S. dollar rose sharply in March due to its role in investment portfolios. Since then, it has fallen about 12% against a trade-weighted currency basket as the U.S. turned out to be even harder to beat with coronavirus pandemic than most major economies.
As vaccines are rolled out and the global economy recovers, this trade may not run back. Instead, the currencies of countries that export goods and manufactured goods are likely to strengthen against the dollar, as would be seen in a normal global recovery. Some Asian exporters are already quietly stepping in to curb the rise of their currencies.
But this time, there will be reasons to expect a weaker dollar to run even deeper. For several years before the pandemic, U.S. interest rates at both ends and short ends of the yield curve were significantly higher than those in Europe and Japan – a major source of strength for the U.S. currency. That price has largely disappeared, however, as the Fed reduced short-term rates to near zero and launched a new round of asset purchases. Yields on 10-year U.S. Treasury notes have fallen from nearly 2% at the beginning of the year to around 0.93% now.
With permission, that is still well above the 0.02% and minus-0.58% yields on 10-year Japanese and German government bonds, respectively. But real yields in the U.S. are indeed lower on the basis of changing inflation, points to markets economist Simona Gambarini of Capital Economics. In the US, the consumer price index was 1.6% higher than a year earlier in November. That compares with some devastation in Japan and the eurozone.
It is very likely that this gap in real rates will soon decline. After all, the Fed promised in August to allow inflation to run above its 2% target for an extended period of time and not respond to falling unemployment with a preemptive rate hike. At the same time, peer-to-peer central banks around the world continue to target inflation rates of around 2% and fall far short of that.
If markets feed it, they will not normally raise the dollar in response to strong inflation or U.S. growth data. This is why Steven Blitz, TS Lombard’s economist, is calling the new framework an effective end to the US government’s traditional “strong dollar” policy.
Consider, for example, how the market might react to a major stimulus package early in Biden’s administration. Large doses of deficit spending are generally seen as dollar-negative as they mean the U.S. needs to bring in more foreign savings. But stimulus could be seen as dollar-positive if it successfully stimulates U.S. growth. This time, however, the Fed has pledged not to raise preemptive rates in response to positive economic news, so a major stimulus package is likely to be undoubtedly negative for the dollar.
None of this has to be bad news for investors. Since most assets are priced in dollars, a weaker dollar often means higher asset prices on everything from stocks to commodities to emerging market bonds . Investors with net worth in dollars should ensure that they diversify, for example by not hedging whether money will appear on their holdings of foreign equity, says Brian Rose, Chief Economist , America at UBS Wealth Management.
The strong dollar may be permanent as a thing of the past. Investors are unlikely to miss it.
This story was published from a wire group group with no text changes.