Dollar’s “weakness”
After the recent decline of the USD against major currencies, the short-dollar narrative has gained steam. But the USD is in fact up for the year in nominal effective terms, as it remains strong against EMFX. Dollar’s demise is far, far away.
Chart of the Week: USD vs DM and EM
DXY, the commonly followed index for US dollar, has weakened 6% since April, giving rise to considerable discussion about the turn in the strong dollar cycle. Two caveats: first, since the beginning of the year, the DXY, which largely reflects movement against the EUR, GBP, and JPY, has rallied only 3.5%. Second, against EMFX, the USD is up about 1.5% so far this year.
Commentary
Rallying gold and cryptocurrencies, weakening USD amidst weak energy prices, and virtually no sign of inflation in the horizon, have been the peculiar market characteristics of the past few months. One would expect the record expansion of the Fed balance sheet and US government debt would cause inflation expectation to rise, which would then follow with a USD selloff. But inflation expectations are clearly not the driver, as the most widely followed gauge, the US 5-yr, 5-yr forward, inflation rate reading just 1.7%. What has then driven the USD to weaken against Euro, British pound, and the Japanese yen?
First, the Fed hitting the zero bound has eliminated a considerable amount of short-term yield (nominal and real) differentiation between the major currencies, taking away the interest rate driven support for the USD. Second, the muscular commitment to a €1.8trln fiscal package by the EU, formalised on July 21, has added considerable tailwind to the Euro.
The dollar’s “weakness” has been with major currencies. In fact, against EMFX, the USD is up so far this year (by 1.5%). Overall, on nominal effective (trade-weighted) basis, it is up 3%.
If present trend persists, and the USD continues to weaken, it may cause inflation expectations to rise somewhat (although the cause and effect are not particularly clear at a time of weak demand). It could also add upward pressure on US interest rates eventually. At the same time, this would add some degree of competitiveness to US exporters (again, not a given in present circumstances). A weaker dollar will drive the additional following mitigating dynamics in the non-USD world:
· Those with USD payables and local currency receivables will find debt service cheaper. With a surge in dollar debt issuance by emerging market sovereigns and corporates in the past decade, this would be a relief.
· In USD terms, investment in non-USD assets will provide better returns, catalysing capital flows non-USD assets. Emerging markets, having experienced considerable capital flow volatility this year, would welcome that.
· As most global trade is denominated in USD, most companies and economies will find imports cheaper in local currency terms. This is particularly beneficial to commodity importers, and most Asian economies fall in that category. Other than the lower cost of imports, this also lowers the risk of exchange rate pass-through driven inflation risks (which is moderate in any case).
· A weak dollar improves the purchasing capacity of consumers in non-USD jurisdictions, providing them with extra motivation to purchase more goods and go out travelling (as most tourism related activities, especially flights and hotels, are linked to the USD), boosting global tourism. This could be particularly critical in the post-pandemic environment.
Finally, for those economies under pressure from the US government on matters of trade imbalance and currency manipulation, a weaker dollar would reduce geopolitical pressure, much needed in a strife-ridden world.