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Greenback blues: Are the doomsayers finally right about the demise of the U.S. dollar?

- Reuters

Every couple of years, a sell-off in the U.S. dollar prompts a group of market watchers — usually, it’s the gold bugs — to warn that a full-blown collapse of the world’s dominant currency is imminent. And every couple of years, the doomsayers are proven wrong.

Over the past few weeks those warnings have once again started to circulate. This time, they’re louder.

The ICE U.S. Dollar Index, which measures the greenback’s value against a basket of six other major currencies, fell 4.2 per cent to make July its worst month since September 2010. That move was only the latest in a prolonged decline for the index that has seen it lose nearly 10 per cent since reaching a high of 102.99 points in March. Against the greenback, the loonie is up six cents in that same timeframe, while gold has hit record highs above US$2,000 per ounce.

The sell-off has led to fresh calls predicting the end of the greenback’s status as a safe haven. Even the dollar’s position as the world’s reserve currency, which has been unchallenged since it took over for the pound after the Second World War, is being brought into question. What’s different this time is that the concerns come against a backdrop of macroeconomic factors so burdensome that even some top economists are calling for the dollar’s continued slide.

“We’ve seen three major corrections in the dollar since the 1970s,” said Stephen Roach, a Yale University senior fellow, referring to  declines that saw the greenback lose about 30 per cent. “ I’m looking at this as the fourth.”

Roach, who teaches classes on Asia’s influence in the global economy and is also the former chairman of Morgan Stanley Asia, is one of several economists, FX strategists and portfolio managers that the Financial Post asked about the dollar’s future. Each one of them was negative on the dollar and called for it to continue its current decline for the next few years, albeit to differing degrees.

Roach was the most negative, warning that the currency could lose as much as 35 per cent of its value.

His own position is built on a forecast that would see the U.S. domestic savings rate tumble into negative double-digit territory and trigger a record current account deficit, meaning the U.S. will be importing far more than it exports. Generally when those deficits rise, the currency falls in order to help correct them, Roach said.

The dollar is also in danger due to America’s diminishing position as a leader on the global stage, Roach said. The U.S . is decoupling itself from globalization and trade protectionism and performing poorly with its COVID-19 response.

“Our role as a global leader is tarnished to say the least,” Roach said.

The dollar has historically been strong when it has found itself on either end of a framework called the dollar smile, Scotiabank chief currency strategist Shaun Osborne said. On one end of the smile — picture a wide “U” shape — the greenback strengthens due to investors becoming risk averse. At the other peak, it rallies because the U.S. economy is growing and demonstrates a yield advantage.

Currently, neither one of these conditions is in place, he said. As foreign economies continue their recoveries, investors are once again willing to take on more risk and redirect some of their portfolios towards emerging markets. The Euro and Yen have appreciated substantially as a result. The U.S. economy, thanks to a poor response on COVID-19, is also lagging.

In a note published last week, a team of Goldman Sachs analysts wrote about how several factors, including a poor economic environment are leading to the dollar’s loss in value and “real concerns” surrounding the greenback losing its position as the reserve currency for global central banks.

The report pointed to rising political and social uncertainty as well as a destabilizing second wave of COVID-19 cases, but crucially, it also highlighted the rising risk of inflation.

“This relentless decline in real interest rates against nominal rates bounded by the U.S. Fed has caused inflation breakevens to rise in an environment that would ordinarily be viewed as deflationary,” said the team, led by head of commodities research Jeffrey Currie. “Ironically, the greater the deflationary concerns that policymakers must fight today, the greater the debt build up and the higher the inflationary risks are in the future.”

Both the U.S. Federal Reserve and the U.S. government injected unprecedented monetary and fiscal stimulus into the markets after a rapid economic shutdown in March led to a stock market crash. The Fed’s balance sheet hit a high of over $7 trillion when it was sitting at about $4.1 trillion prior to the shutdown. The U.S. government, meanwhile, passed a US$3 trillion stimulus bill and the Democrats and Republicans are currently negotiating a second bill that seems likely to surpass an additional US$1 trillion.

The expanding balance sheets, the Goldman team wrote, further supplant debasement fears. And because an interest rate hike in the current economic environment would do more harm than good, the central bank is left with having to push inflation targets higher. Recent comments from officials suggest the Fed could potentially move from a strict two per cent inflation target to an average target of two per cent, meaning there will be times where it overshoots the former benchmark.

“That has led to sentiment in some parts of markets or financial markets that the U.S. dollar should be valued less than a currency that has an inflation target,” said CIBC senior economist Royce Mendes.

Mendes also projects that the dollar is set to continue to weaken, but isn’t as bearish as Roach. Instead of an historic slide, Mendes is looking for a single-digit percentage decline over the next several months. “Calling for anything more severe is a mistake,” Mendes said.

Mendes’ outlook is in-line with that of Capital Economics senior U.S. economist Andrew Hunter, who sees the greenback shedding an additional five per cent over the next two years.

Neither one of them sees the dollar entering a freefall so deep that it would convince global central banks to move away from it.

“I don’t think that’s remotely under threat,” Hunter said. “Our forecast is really just about getting back to more normal levels.”

The dollar index has already lost the pandemic bump it received in March and has drifted further down to trade at levels last seen in April 2018. That could spell bad news for Canadian investors, particularly those that bought U.S. stocks when the dollar was close to its all-time highs. Even if their stocks don’t move, the weakening dollar would take a bite out of their returns.

Jamie Robertson, the global head of tactical allocation for Manulife Investment Management, also expects further weakness in the dollar but isn’t allowing it to influence many of his decisions in terms of portfolio management. Robertson said he does incorporate currency forecasts into portfolio construction, but weak projections for either the loonie, the greenback or the Euro don’t mean that the stocks sold in those currencies aren’t worth buying.

“It’ll be a headwind for returns but it’s not a sufficiently strong market to not be invested in U.S. markets,” Robertson said. “You go in with your eyes wide open and you may have a headwind from the currency perspective but it doesn’t take away from the fact that it’s a compelling investment.”

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