Extract from our "The Dollar and the Economic Recovery" research paper, published 1st July 2020
There is a remarkably strong consensus opinion that the dollar will weaken meaningfully over the coming quarters as the global recovery extends. Some have even forecast an imminent dollar collapse as an international and reserve currency. We contest both of these consensus views and believe the dollar will perform just fine in this cycle. The dollar can of course weaken, but we think the likely drivers are not what some may think.
- In contrast to the prevalent opinion, we don’t believe the dollar has a linear/monotonic relationship with risk or the US’ growth premium; we continue to believe the Dollar Smile is a good description of the cyclical characteristics of the dollar. Risk rallies leading a recovery from a global recession can be dollar negative initially, as the rest of the world rebounds; but the correlation will likely flip to positive if the US leads the global economy, as it has on many past cycles, and as we believe it will, in the current recovery.
- The US is a fundamentally dynamic economy that should permit a relatively swift process of ‘creative destruction’, which would put the US on a more robust medium-term growth path. Thus, the USD might lag behind other currencies in the initial phase of the normalisation process; but ultimately, we expect to see the USD reassert itself.
- Current account balances no longer drive G7 currencies: capital flows are much more important, particularly around turning points of a cycle. When the world is in the ‘fear’ mode, bond flows drive the dollar; when the world is in the ‘greed’ mode, equity flows drive the dollar. But if we believe bonds are overvalued relative to the long-term sustainable potential nominal GDP growth rate, and equities are also overvalued, then why should investors be singularly troubled by modest mispricing in the dollar? The dollar is indeed moderately overvalued, but we do not believe the level of mispricing is sufficiently extreme to drive the dollar lower.
- The USD losing its dominant international currency status in the near-term is simply not a credible scenario, in our view.
- Economic policies post the US Elections in November, however, pose the biggest threat to both US equities and the dollar, in our view.
It is rather remarkable that against this highly uncertain global backdrop, full of economic, political, and health risks, analysts’ collective view on any asset class could be so universal and definitive. We challenge this dollar bearish view, both on the reasoning behind the call and on the call itself. We believe the dollar ought to perform just fine in the coming quarters (i.e., the dollar index should be stable to modestly stronger: strengthen modestly via-a-vis the EUR but weaken relative to the CNY). Having said this, our relatively constructive outlook for the dollar is not unconditional. Importantly, we assume that the US economy will lead the world in the recovery, even if not in the very initial phase: US out-performance is necessary for a move to the right side of the Dollar Smile. The prospective dollar appreciation we envisage may nevertheless be relatively modest, in light of the Fed’s dovish stance. Finally, if the dollar falters next year, we guess the biggest culprit might be a dramatic change in economic policies after the US Elections.
Extract from The Dollar and the Economic Recovery, published 1st July 2020
Sections included within this report are:
- A strongly negative consensus view on the dollar
- The Dollar Smile framework
- The prospective US and global economic recoveries
- A ‘square-root’ trajectory
- Dollar over-valuation
- Inflation targeting framework to come under scrutiny
- The Fed’s dovish stance
- US Elections in November
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