Is the US dollar’s downtrend ending?

Frankfurt The US dollar has seen volatile times. Since the beginning of May, the US currency has depreciated almost eight percent against the euro. Recently, however, the downward trend has turned and the dollar was one of the winners in the foreign exchange market.

The question, however, is whether this uptrend is sustainable for the dollar. Many forex experts are skeptical. “That the dollar can recover a little after months of weakness is unaffected. However, one should be surprised that this recovery will take place a few weeks before the US presidential election, ”says the verdict CommerzbankForeign exchange expert Ulrich Leuchtmann. The investment strategist of French wealth manager Carmignac, Gergely Majoros, still believes the US currency is overvalued. He sees potential for further devaluation, especially given the extremely loose monetary policy and massive government spending in the USA. “Historically, the dollar has always suffered particularly when monetary and fiscal policy in the USA was very expansionary,” he says. The head of foreign exchange is even clearer German bank, George Saravelos. In a recent analysis, he speaks of the “worst policy mix for the dollar since the end of Bretton Woods”. An allusion to the historic monetary agreement after the Second World War, which collapsed in 1973.

As reasons for his dollar skepticism, Saravelos points to both the poor starting position and the risks in the coming months. For example, real interest rates in the US are currently lower than ever, i.e. nominal interest rates minus inflation. In response to the corona crisis, the American Federal Reserve lowered the key interest rate from up to 1.75 percent to 0.25 percent in the spring. Similar to the Fed, other central banks also eased monetary policy. The bottom line, however, is that the interest rate differential between the United States and the rest of the world has decreased in the corona crisis. This plays an important role for international investors: if interest rates fall more sharply in the USA than elsewhere, it becomes more attractive for them to invest in other currency areas.

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US budget in even deeper red than already thanks to Corona

It looks similar to monetary policy in financial policy. Here, too, practically all countries run higher deficits during the crisis, but the US stands out in particular. Even before the corona crisis, the budget and the current account were deep red, i.e. the balance in trade in goods and services with foreign countries. For this year, the long-term budget outlook forecasts a 16 percent decline in economic output for the budget alone – the highest deficit in peacetime. Deutsche Bank analyst Saravelos assumes that this, together with the negative current account balance, will result in the highest twin deficit of all time for the USA. This in turn means that the United States is reliant on high capital inflows from abroad – which tends to weaken the dollar. A worsening twin deficits are “an important negative factor for the dollar,” says Saravelos. Compared to the USA, other countries held back during the crisis. “China is nowhere near as much as it was after the 2009 financial crisis,” emphasizes Majoros from Carmignac. At that time, the country had launched a massive economic program.

In view of the dwindling interest rate advantage of the USA over many other countries and high deficits, the dollar is in a difficult position. There are also serious risks in the coming months – above all from the US Senate and presidential elections on November 3rd.
Deutsche Bank analyst Saravelos reckons with a double success of the Democratic presidential candidate Joe Biden and his party in the elections for the Senate with tax cuts for lower income groups and a higher burden on capital income. “This would widen the current account deficit through higher consumer spending and dampen capital inflows into the US through higher capital taxes.”

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Another important topic in the capital markets is the search for a vaccine against the coronavirus. Saravelos said a success in the vaccine search could also weaken the dollar. He relies on the relationship between the dollar rate and risk sentiment in the markets. The US currency tends to be in demand when investors avoid risks. However, a vaccine would have the opposite effect: it would generate optimism and an increased risk appetite among investors. Saravelos believes a cyclical sector-led stock rally is possible and expects a weaker dollar.

But which currencies benefit in return? In the past few months it was mainly the euro. Most recently, however, leading representatives of the European Central Bank (ECB) have warned of the risks of a further appreciation of the European common currency. A strong euro is undesirable for the ECB because it makes imports cheaper and thus further depresses the already extremely low inflation in the euro area. On the other hand, it makes exports more expensive and less competitive on the world market.

The ECB could intervene

The ECB could therefore take countermeasures if the euro continues to gain. For example, through further verbal interventions or by topping up their bond purchase program in the corona crisis to the current amount of 1.35 trillion euros.

This would tend to counteract a further appreciation of the euro. Deutsche Bank expert Saravleos therefore considers the dollar’s depreciation potential against the euro to be limited – despite his skepticism about the dollar. In the event of broad-based dollar weakness, he expects the euro exchange rate to rise above 1.20 US dollars per euro towards the 1.25 US dollar mark.

In contrast, he sees significantly greater potential for other G10 currencies such as the New Zealand dollar, the Australian dollar or the Norwegian krone, but also for emerging market currencies such as the Brazilian real and the South African rand. The latter have come under particularly strong pressure in the corona crisis: The Brazilian real has depreciated by around 40 percent against the dollar since the beginning of the year and the South African rand by around 22 percent. Saravelos currently considers both currencies to be very low valued. Overall, they and other emerging market currencies would benefit from a better growth outlook, stronger fundamentals and extremely favorable liquidity conditions around the world.

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Weak dollar helps emerging markets

For the global economy, too, a depreciation of the dollar against the emerging market currencies would tend to be better than against the euro or the Japanese yen. The chief economist of the Institute for International Finance (IIF), Robin Brooks, for example, points to this connection. “It would be necessary for the dollar to fall against emerging market currencies. That would ease funding conditions and boost global growth, ”he wrote on Twitter. In contrast to the euro area and Japan, where a further devaluation of the dollar tends to increase the risk of deflation, another effect is more decisive in the emerging countries: because many companies and some countries there have borrowed in dollars, a weaker one makes it easier Dollars servicing the debt. An appreciation of the emerging market currencies against the dollar thus acts like an easing of monetary policy.

Whether currencies like the Brazilian real or the South African rand will gain again against the dollar, however, also depends on how these countries cope with the burdens of the corona crisis. At least their ratings are now very low. The dollar has recently lost some of its value against the euro, but the bottom line is that it has had a long period of strength in recent years. There are clear risks in the months ahead that could weaken it.

More: Concerns about inflation weigh on Eastern European currencies


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