According to Zach Pandl from Goldman Sachs, Recent depreciation in the broad US Dollar may be just the beginning of a larger structural downtrend, reflecting the currency’s poor medium-term fundamentals.
After surging earlier this year, the broad US Dollar has begun to turn lower. Our daily measure of the real trade-weighted Dollar (GSUSDRTW) has declined about 5% from its average in April and the first half of May. In part, the recent weakness in the broad Dollar reflects appreciation in a few “high beta” Dollar crosses—especially the Canadian Dollar and Mexican Peso—alongside the rally in risky assets generally. But we increasingly think that the recent moves may be just the beginning of a larger structural downtrend in the greenback, reflecting the currency’s poor medium-term fundamentals.
The Dollar entered the coronavirus recession already overvalued, and its appreciation in February and March stretched valuations further. Based on our GSDEER model, the trade-weighted Dollar was about 20% overvalued before its recent decline. At the highs in March, the real trade-weighted exchange rate also came within about 2% of the highs in the last Dollar cycle, which ended in February 2002. Given its high initial valuation, we argued at the start of this month that the greenback may fall more than 20% over the coming years if the global economic recovery can be sustained. This is often how the broad Dollar has behaved in the past, pivoting from sustained appreciation to sustained depreciation, with occasional sideways moves in between. In past trending environments, the Dollar has tended to shift an average of 30% over a period of five years (Exhibit 1).
Exhibit 1: US Dollar Pivots between Sustained Appreciation and Depreciation
Source: Haver Analytics
In recent years the Dollar has benefited from persistent portfolio inflows into US markets, reflecting high yields compared with other developed market economies, and this has underpinned its high valuation. That positive fundamental has now changed: the Fed has reduced rates to their effective lower bound, and FX volatility has picked up. As a result, vol-adjusted carry in the Dollar is now relatively low on most G10 crosses (Exhibit 2, left panel). On a broad trade-weighted basis, incorporating EM exchange rates, front-end rate differentials have widened from close to zero in late 2018 to around 150bp now (Exhibit 2, right panel). Lower yields do not necessarily mean overseas investors will sell US assets, but we would expect fixed income portfolio inflows to slow, and for some investors to begin hedging FX risk in cross-border positions in both fixed income and equities, given much lower hedging costs.
Exhibit 2: Fed Rate Cuts Have Eroded Dollar’s Yield Advantage
Source: Bloomberg, Goldman Sachs Global Investment Research
Despite high valuations and lower yields, until recently we had discouraged investors from positioning for Dollar weakness in portfolios, because the currency is a counter-cyclical asset (against all but a few crosses) and we remained concerned about a pickup in virus transmission as the reopening process got underway. While not definitive, the lack of a widespread pickup in infection rates in the early-open states and countries suggests the virus may be controllable through only moderate interventions, such as mask wearing and avoiding the most crowded public events. For this reason, we have now recommended more pro-cyclical trades across assets, including longs in non-Dollar currencies. The Dollar’s negative correlation to the health of the global economy and investor risk appetite reflects structural factors, including the safe haven role of US Treasuries and the fact that the currency denominates an outsized share of cross-border lending and international trade (for more background, see here, here, and here). These features are unlikely to change soon, suggesting a further recovery in the global economy should reinforce a depreciation trend in the US Dollar.
Two additional medium-term issues could also weigh on the Dollar over time. First, a number of sovereigns have attempted to diversify their reserve assets away from the Dollar in recent years, partly for political reasons. This may continue if the United States adjusts its approach to multilateral institutions and overseas military commitments. As economist Barry Eichengreen has documented, political considerations, including military alliances, have long played a role in the currency composition of foreign exchange reserves. Second, heavy Treasury issuance in the coming years may put downward pressure on the Dollar. Foreign investors already hold large Dollar balances, and they may need to be compensated to increase their holdings further. That compensation could come in the form of higher interest rates, but if the Fed keeps rates low over the coming years, it may instead come in the form of lower prices in foreign currency terms—i.e., through Dollar depreciation (see here for more background).
We see two main risks to our view of sustained Dollar weakness. First, the cyclical outlook could deteriorate again, perhaps on a second virus wave and renewed lockdowns. If major economies slip back into recession, the Dollar’s safe haven appeal would likely return, stalling any depreciation trend (although if infection rates rose in the US but not elsewhere, implications for the Dollar would be more ambiguous). Second, US assets may continue to outperform, supporting inbound portfolio investment and the Dollar. For example, although European and other non-US equity markets have outperformed in recent weeks, this follows a long period of underperformance, and investors may still have doubts about the earnings potential of the cyclically oriented firms that dominate European equity markets. As shown in Exhibit 3, compared with the US, European equity markets are overweight the sectors which have delivered relatively low earnings growth over the past decade—especially banks. More deeply negative rates in the Euro area or substantial rate cuts in other major economies may also hold back Dollar weakness.
Exhibit 3: European Equity Markets Overweight Low-Growth Sectors
Source: Bloomberg, Goldman Sachs Global Investment Research
For portfolios today, we prefer longs in non-Asia, pro-risk currencies with decent FX fundamentals; risks to the Euro are also skewed to the upside, in our view. For the time being, we think most (Non-Japan) Asian currencies should be avoided due to the risk that bilateral disputes between the US and China escalate again, but they would likely participate in Dollar depreciation eventually, if a sustainable downtrend takes hold. Among G10 currencies, we think the single best USD short opportunity is in NOK, reflecting the Krone’s low valuation and Norway’s unique fiscal framework; in EM we favor USD shorts vs MXN. Although we forecast only a gradual appreciation in EUR/USD, risks are skewed toward faster appreciation. As our European economists have pointed out, recent news on the Euro area has cut in a clearly positive direction, reflecting low COVID infection rates and a pickup in activity data, the ECB’s expansion of the PEPP program, and progress on the EU Recovery Fund. The Recovery Fund in particular, assuming it gets off the ground, could represent a major step toward greater fiscal policy coordination in the region and, importantly, a new source of highly-rated Euro-denominated debt for global investors—missing features which, up to now, many observers have considered reasons why the Euro would struggle to compete with the US Dollar for a central role in global trade and finance.