During the pandemic, the US dollar benefited from its safe-haven status. The following relatively rapid economic turnaround also played in its favor. But with the exuberant build-up of US government debt, the dollar is playing a dangerous game: risking its credibility. On the short term, support can be expected as monetary policy tightens. But on the longer term, the dollar is doomed to weaken.
A turbulent history
A year ago, in full corona panic, the greenback lived up to its reputation as a safe-haven asset. The pandemic made investors risk-averse, and they fled to quality government bonds in dollars, pushing the US dollar from 1.12 USD/EUR in early March up to 1.06 USD/EUR two weeks later. By the summer, the panic had largely melted away, and with it the appetite for US bonds. The dollar weakened slightly amid mixed news about a vaccine breakthrough, the gradual reopening of the economy, the second coronavirus wave, and new stimulus packages from central banks and governments. At the start of the new year, we began to see the light at the end of the American corona tunnel. The vaccination campaign went smoothly, lockdowns were relaxed, and the engines of economic growth (first production, then services) were restarted. This economic optimism was accompanied by expectations for rising inflation and interest rates. In mid-February, the US 10-year yield was already at 1.7%, a sharp increase from 0.9% at the start of the year. US government bonds again yielded some interest; the dollar bounced. Enter brand-new President Joe Biden, who announced massive aid packages in the early months of 2021. Price tag: > $4 trillion. If these plans are approved by the House of Representatives and the Senate, they will bring the US debt ratio to about 120% of the gross domestic product (GDP). For comparison, the eurozone’s debt ratio is 98%. Analysts are none too pleased with this development. Will the US ever be able to pay back this towering debt? This uncertainty weighed on the US currency in recent weeks, as did the strong recovery of not only the American economy, but also the European, as indicated by the declining USD/EUR exchange rate. This decline was even more pronounced against certain emerging market currencies and commodity-related currencies. The dollar index, which expresses the value of the US dollar against the value of a basket of foreign currencies, has been crumbling steadily (-10% over 12 months).
Anyone who dares to give an accurate prediction of the dollar today is walking on thin ice. Things used to be different, when analysts could accurately map out an exchange rate’s trajectory based on the real interest rate differential (the interest rate differential between two countries or regions, adjusted for the rate of inflation). But now other factors, such as monetary policy and the economic recovery, are making more significant contributions. The Federal Reserve (the US central bank, the Fed) faces a delicate balancing act. The recent high inflation figures cry for attention, but at the same time the Fed is terrified of crippling the fledgling economic recovery. Chairman Powell must balance the target for inflation (average 2% inflation on the medium term) against that for (maximum) employment. Currently, the Fed is buying about $120 billion in Treasury bonds and repackaged mortgages each month. More and more voices are making a case for tapering. If inflation also becomes sustainable—for example because the scarcity on the labor market is pushing up wages—an interest rate increase can no longer be ruled out, even if it is not for tomorrow. On the short term, the prospect of a monetary policy adjustment may provide temporary support to the dollar. Econopolis therefore predicts stabilization at the current levels for the time being. Either way, the US yield curve is getting steeper. The 10-year yield is currently at 1.5%-1.6%, back at its level from end-2019, but the short-term interest rate is still close to 0%. The real interest rate (nominal rate minus inflation) is now very negative, implying a de facto depreciation of the dollar.
Will the dollar maintain its reserve currency status?
What will the dollar do on the longer term? That's another story, because on the long term it will be impossible to ignore the United States’ expansive fiscal policy. The budget deficit for 2020 was 15% of GDP; for 2021 it is estimated at 10%. Further into this decade, official US government departments are counting on deficits at about 4% of GDP, and that percentage is likely to increase after 2030. US long-term debt will, course, evolve accordingly. And then comes the delicate balancing act. Because who will want to finance such colossal debt? Everything hinges on trust and credibility. The dollar was once the undisputed international reserve currency for central banks. But meanwhile, competitors lie in wait, such as the euro. The Chinese renminbi is also gaining in importance. In 1999, the dollar's share in central banks’ reserves worldwide was over 70%. In Q4 of last year, that share had eroded to 59%. Reserve currency status is crucial for the dollar if it is to find buyers for that immense supply of government bonds. Russia's recent announcement that it will reduce its dollar reserve in favor of gold and the renminbi is a bad sign. Will the dollar remain the safe haven in times of adversity? Not everyone is convinced. On the longer term, Econopolis sees the dollar weaken further.
Investing in a weakening dollar
Who benefits from a weaker dollar? In the first place, export-oriented American companies, which can sell their goods more cheaply abroad. Yet at Econopolis, we do not see a declining dollar as the driving factor for American stock markets. Rapidly growing domestic consumer demand, healthy earnings growth and high profit margins are more compelling reasons to invest in US stock markets. Emerging markets will undoubtedly benefit from a structurally weaker dollar. To inspire confidence in investors, they usually issue bonds in a fixed currency. Such bonds are often denominated in dollars. A weaker dollar directly lowers the debt burden on these economies. A second winner in our opinion is gold. With the money supply (M2) rising by no less than 25% in 2020 as central banks continue to churn out cash alongside a very negative real interest rate, gold has become the scarce commodity par excellence. In contrast to trendy crypto coins, gold has built up a track record over millennia as an inflation-proof investment.
During the pandemic, the dollar attracted risk-averse investors as a safe-haven asset. The US currency also benefited from an economic recovery faster than in Europe. However in the months and years to come, the dollar’s credibility will be put to the test. Will financiers continue to swallow the avalanche of government bonds that result from an expansionary fiscal policy? The dollar will have to defend its status as a reserve currency with fervor, because other candidates are lurking.
Macro Economist and Wealth Manager at Econopolis.