Is the decline of the dollar over? The US currency has been falling steadily ever since the world exited the initial stage of the Covid-19 crisis. It has done so in line with the spectacular decline in real yields. This makes perfect sense. With lower yields, there is lower “carry” to be earned by parking in the dollar, so the currency would be expected to weaken.
But last week ended with a distinct variation of the theme. The 10-year real yield dropped below minus 1% for the first time since inflation-protected Treasury bonds have been on issue. Meanwhile the popular dollar index, which compares the currency to a group of leading counterparts, suddenly enjoyed its strongest rally in months, gaining almost 1% into the close.
A weaker dollar is generally regarded as a desirable for a number of reasons. A strong dollar tends to mean that money has gone into the US seeking a haven, so the slide of the last few months shows a return of risk appetite, even as the virus remains unbeaten. Also, a strong dollar causes problems for emerging markets. The depreciation of the last few months should have relieved pressure on a number that had taken on too much dollar-denominated debt.
The only problem is that this hasn’t in fact happened. The following chart, from NatWest Markets, shows that the dollar’s weakness of June and July has been almost solely about the strength of other developed-market currencies, particularly the euro. Against Asian currencies it has held steady. And against “high-yield” emerging market currencies, it has actually strengthened. Those high-yield currencies enjoyed a recovery as the worst of the crisis appeared to pass in May — they have fallen over the past two months.
The weaker dollar may not, then, have been as positive a sign as was hoped. The main reason the high-yielding currencies remained weak was because their central banks had no choice but to cut rates in the face of the pandemic. That substantially reduced the advantages to holding money in those currencies. This NatWest Markets chart shows that despite the precipitous fall in US real yields, emerging markets rates are at the narrowest spread over rates in the G-10 since the taper tantrum of 2013. Potential pressure on emerging markets remains considerable if the dollar begins to regain strength.
The greatest hope to avoid a classic emerging markets debt-and-devaluation crisis is that central banks’ actions haven’t spurred inflation, yet. Citibank’s inflation surprise indexes suggest that investors were unprepared for the scale of the slowdown.
In the week ahead, which has the customary glut of macro data to accompany the beginning of the month, the central banks of Brazil and India will meet. Both are expected to continue easing, as they deal with what appear to be serious virus outbreaks. Those meetings, along with Tuesday’s gathering of the Reserve Bank of Australia, another country that is grappling with a serious Covid resurgence, will be more closely watched than usual.
What will drive the dollar from here? After such a prolonged downdraft, it looked oversold on plenty of measures, so we might well see it bounce back further aided by technical factors. But the virus, as ever, may have most to do with it.
The critical flaw in the dollar over the last two months has been the deterioration in the public health situation in the US, while other countries continued to have the virus under some kind of control. As Marc Chandler, foreign exchange strategist at Bannockburn Global Forex in New York, puts it:
There is no reason to expect the investment climate is going to change next week. The key drivers remain the same. The resurgence being seen in the virus is posing a speed bump in the re-opening and recovery process. The work of monetary and fiscal policy is not over. The low real and nominal interest rates are encouraging risk-taking by savers, and this means equities, commodities, and emerging markets.
Until there is a vaccine that is widely available, flare-ups seem inevitable. The issue is how long it takes to bring it back under control. Even without new national lockdowns, the economic impact can be palpable. It may provide a speed bump of sorts to the pace of the recovery.
Bloomberg
