The global influence of the US dollar

By Tim Sharp, Hottinger Investment Management 

The US dollar index (DXY) is up 1.4% year-to-date when many started the year with a weak dollar stance on the back of a flip flop in policy by the Fed scaling back potential tightening measures.

UBS publish in their FX Outlook 2020[1] that the short-term dollar trend seems to have switched lower with a weakening economic outlook that they expect to lead to continued weakness in the first half of 2020 and further easing by the fed before activity recovers in the second half of the year. They further argue that this scenario will see US investors less likely to invest in overseas assets, with the threat of global slowdown thereby undermining any strength in emerging market assets that may have resulted from the weak dollar.

Knowing where we are now, we have made the case a number of times this year for a strong dollar and find it interesting that there are analysts who now believe that the dollar should have been stronger during 2019 due to its superior growth rate amongst the developed countries. The second half of the year has seen a growth scare and a corporate profits scare followed by a rebound in consumer sentiment measures that have increased dollar volatility but also underlined the safe haven flows that underpin dollar strength.

Capital Economics calculates that the trade-weighted dollar is at its highest since Trump became President in 2017 and more than 25% higher than its post global financial crisis lows in 2011. However, they argue that the dollar is only 6% above its average since the 1970s and is a lot lower than the peaks of the mid 1980s and early 2000s[2] which means that there is still room for the dollar to strengthen from here.

Absolute Strategy Research (ASR) has recorded that over the past 20 years weak global growth momentum and rising policy uncertainty have tended to be associated with a strong dollar. Furthermore, this pattern continued in 2001 – even with the US at the centre of the global recession – when the dollar fell after the recession had ended. Therefore, for there to be broad-based dollar weakness, there would need to be stronger global growth outside the US, encouraging US investors to invest in foreign assets with non-US real yields to rise relative to US real yields[3].

The Financial Times article by Jonathan Wheatley on December 5[4] highlighted the current risk of contagion returning to the emerging world, most notably in Latin America. Argentina, Bolivia, Brazil, Chile, Ecuador, Peru and Venezuela have all been affected by crises, coming to a head in the last quarter with most countries having little or no room for fiscal stimulus.

Our website article dated October 22[5] also highlights the changes in China as it moves from capital investment to a more consumer-based economy and the very low likelihood of the Chinese authorities adding enough stimulus to reignite the global economy as they have in the past.

In summary, it looks unlikely that emerging markets will be able to provide the impetus to global growth in 2020 and ASR points out that the dollar’s refusal to weaken significantly suggests many of their central banks will be unable to lower rates much further without risking capital flight.

Safe haven flows, as the US-China trade war and interest rate differentials remain, will continue to favour the dollar, despite attempts by President Trump to meet his campaign pledge to eliminate the trade deficit and make the US more competitive through a weakening of the dollar. With the support that a low exchange rate lends to trade, it is likely that other developed nations would prefer the situation to continue in the light of US protectionist policies and the macroeconomic backdrop.

We continue to believe that the global economy is in late cycle, not mid cycle, and that the US is about to join the major economies of Europe, including the UK, on the brink of a shallow recession in 2020 that is unlikely to be saved by a US-China phase 1 trade deal. ASR summarises that the dollar has been the main channel of transmission for US monetary policy, pushing the dollar higher and thereby creating a drag on global financial conditions and depressing global growth. This will continue unless the Fed eases further.

Finally, although it is still too early to speculate on the outcome of the 2020 US presidential election, the differing views of the candidates will undoubtedly influence the path of the dollar going into the second half of the year. President Trump has taken a lot of credit for the state of the US economy and the returns from US financial markets, so it will be interesting to see how he approaches a weaker period during the presidential race. His attacks on Fed Chair Powell in recent weeks and his tweets regarding the use of negative rates by Europe would suggest that he intends to lay the blame firmly at the feet of the Fed, with the potential consequence of undermining the Fed’s independence. Democratic candidates could have different impacts on the dollar, with Lombard Odier suggesting that a Warren presidency would be dollar negative while a Biden or Bloomberg presidency would probably be dollar neutral[6]. However, the US presidential election will be held on November 3 next year, so plenty of opportunities yet remain for the incumbent to exert his influence and for global markets to follow their own path.

[1] UBS Global Strategy. FX Outlook 2020: Wither the dollar?

[2] Capital Economics. Global Markets Update. 2nd December 2019

[3] Absolute Strategy Research. Global Asset Allocation: Staying defensive on high 2020 recession risk.

[4] https://www.ft.com/content/7e4e580e-168e-11ea-9ee4-11f260415385

[5] https://hottinger.co.uk/sino-stimulus/

[6] Lombard Odier. The dollar and 2020 US presidential elections: protectionism and trade policies at the forefront by Vasileios Gkionakis, PhD. Global Head of FX Strategy.