Trade-weighted dollar exchange rate (nominal broad index of the Federal Reserve) line graph showing the 2020 dollar retreat in a long upswing

Long-term forces stack against the dollar

Alarm bells have rang in the financial markets in the past few days. The US dollar has found its level, reflecting its port status as stocks and investor sentiment weaken. However, this could prove fleeting given the longer-term forces stacking against the world's reserve currency.

Since rising to its best level since 2002 following the pandemic earlier this year, the Federal Reserve's trade-weighted dollar index has been put under pressure by a combination of rising trade and budget deficits, along with expectations that US interest rates will be extremely low for a longer stay. Despite rising this week as global stocks posted their largest weekly decline since the March turmoil, the dollar is still 9 percent down from its high this month.

A weaker US currency acts like a safety valve in a global financial system that is heavily reliant on US dollar-denominated debt and trade flows, especially for emerging markets. A moving dollar also supports US business when interest rates are anchored near zero.

A renewed dollar weakness could well follow given the challenges for the US economy, even after the record growth in the third quarter. Some economists believe a return to pre-pandemic U.S. production won't come until late 2021. With coronavirus hitting a contested service sector and employment outlook soaring, there is a threat of additional incentives following the US presidential and congressional elections next week.

"Regardless of the election result, the dollar has entered a cycle of relative decline," notes Marc Chandler, chief strategist at Bannockburn Global Forex. “The old twin deficit meme is coming back. The weakening dollar will act as a shock absorber to the economy. "

According to official information, the pandemic has already led to a sharp deterioration in the US trade deficit in goods and services this year. As for government spending, the Congressional Budget Office projects a budget deficit of $ 3.3 billion in 2020, accounting for 16 percent of GDP and the largest loan amount since 1945. For the 2021 financial year, the CBO expects the deficit to stand still at 8.6 percent of GDP.

Line chart of the US federal government's budget balance as a percentage of GDP showing deficits matter to the US dollar

So far, rising deficits have failed to raise long-term US interest rates significantly. This reflects expectations of a long recovery process for the US economy and jobs, as well as a Federal Reserve poised to expand its balance sheet and buy a lot more government bonds.

Expanding the US Federal Reserve's balance sheet could be given greater urgency in light of an important aspect of the global pandemic, a recovering Chinese economy and its currency.

The renminbi gained around 4 percent this year, reaching a level last seen in July 2018. This was helped by an increase in exports and the inclusion of domestic bonds in major global indices. The renminbi's recent strength has been tolerated by Beijing, indicating its willingness to open the Chinese economy to greater foreign financial flows over the next decade.

This long-term shift could also result in Beijing holding non-US dollar-denominated assets, which helped offset the US current account deficit. Alan Ruskin, strategist at Deutsche Bank, identifies alternatives such as gold, the euro, the Japanese yen and the Australian dollar that result from a break in China's previous willingness to "establish a symbiotic relationship with the US."

This increases the prospect that further dollar deterioration and an improving global economy could ultimately trigger sharp foreign outflows from Wall Street. After nearly a decade of rally for the dollar, global investors are overweight US stocks that look expensive compared to the rest of the world.

This gets to the heart of the debate about the ultimate rate of the dollar and how it will affect the world economy and international stock markets. The bear fall for the dollar reflects the pressures of twin deficits and the Fed's growing balance sheet. Even a moderate recovery in the US economy will attract more imports and fuel the growth of other economies and their currencies.

The alternative scenario is for much greater than expected US domestic growth should there be further fiscal stimulus for the US and a revival of consumer deferred spending. In such circumstances, a broader US equity rally could emerge, led by smaller and cyclical companies. There would also likely be less support from the Fed.

Longview Economics' Chris Watling argues that the dollar may come as a surprise to bearish investors given the extent of excessive household saving. They estimate this increased by more than $ 1 billion during the lockdowns.

“The US has the capacity for the biggest surge in growth once the pandemic ends or a vaccine arrives. A bigger driver of the dollar is the combination of robust growth and higher returns rather than worrying about twin deficits, ”he says.

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