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The End of the Dollar’s Remarkable Surge

By Nick Sargen
Economics
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us dollar
  • After rising by nearly 40% throughout the past decade, the U.S. dollar has come under pressure since late March declining by about 6% on a trade-weighted basis. The weakening is linked to accommodative U.S. monetary and fiscal policies to combat the COVID-19 pandemic.
  • The dollar’s softening has also coincided with a surge in the price of gold to a record high. However, the U.S. bond market is not signaling a quick resurgence of U.S. inflation.
  • The dollar is likely to remain under pressure for the balance of this year and into next year. However, a full-blown loss of confidence is unlikely and the dollar’s status as the world’s reserve currency is not likely in question.

Background: The Turn in the Dollar

The U.S. dollar had a remarkable run over the past decade, rising by 38% on a trade-weighted basis (Figure 1) amid the longest U.S. economic expansion on record. The dollar’s trade-weighted appreciation in this period was shy of its 45% rise in the second half of the 1990s but lasted twice as long.  

Most of the dollar’s rise occurred from 2015 when the euro was severely strained and China experienced a growth slowdown. Investors were attracted to it by relatively favorable U.S. economic performance and positive interest rate differentials versus the euro-zone, where interest rates eventually became negative.  

the trade weighted u.s. dollar index, 2010 to end-july 2020The dollar’s strength lasted until the first quarter of this year when the U.S. economic expansion was aborted by the COVID-19 pandemic. The turning point in late March coincided with unprecedented U.S. policy actions to combat the effects of social distancing and shutdowns of U.S. businesses. 

For its part, the Federal Reserve quickly lowered interest rates to zero and augmented bond-buying programs it launched during the 2008 financial crisis.  Pressures on the dollar subsequently intensified after the June FOMC meeting, when Chairman Jerome Powell emphasized that “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.”

Meanwhile, investors are awaiting Congressional action to bolster the economy and lower unemployment. Federal programs enacted to tackle the pandemic currently tally $3.3 trillion and according to the Congressional Budget Office will boost the federal deficit by $2.5 trillion. Democrats favor additional programs totaling $3 trillion while Republicans initially opposed legislation that exceeded $1 trillion. A compromise bill is expected to be enacted shortly that will boost the federal deficit further.

Surge in the Price of Gold

Pressures on the dollar have coincided with a surge in the price of gold, which has risen by 30% this year to a record high just of $2,000 per ounce (Figure 2).  Many investors have been attracted to it as a safe haven amid the prospect that outsized budget deficits will be monetized and eventually lead to higher inflation.

the surging price of gold, 2019 to end-july 2020

Thus far, there is little to indicate that inflation or inflation expectations have increased materially. Treasury bond yields, for example, are at or near record lows, and inflation expectations as measured by the spread in Treasury yields versus Treasury Inflation Protected bonds (TIPs) are also low, running at about 1.5%.

Much of the appeal of gold is it is perceived to be a hedge during times of economic strain and heightened uncertainty. Considering that there is no prior experience of a pandemic in the post-war era, investors view gold as a safe haven either if inflation accelerates or if deflation adds to financial strains.  

Prospects for the Dollar: A Benign Decline

Looking ahead, a quick reversal in the dollar’s fortunes is not anticipated. Since the breakdown of fixed exchange rates in the early 1970s, the dollar has fluctuated over cycles that typically last about five years or so. What is unusual is that it stayed strong throughout the past decade. This mainly was due to strains in the euro-zone related to problems with Greece and the European Union (EU) periphery, concerns about the U.S.-China trade conflict, as well as a record U.S. economic expansion.
 
In the wake of the COVID-19 pandemic, however, the euro-zone may be better positioned for a quick recovery because cases in the EU have been brought under control versus a resurgence in the U.S. Also, the prospect that U.S. interest rates will remain close to zero for the next year or two means that interest rate differentials no longer favor the dollar relative to the euro. It has appreciated versus the dollar by 9% since late March.
 
The upcoming U.S. elections also adds to uncertainty. In the months ahead, investors will be assessing economic policies pertaining to federal government spending and taxes, the size of the budget deficit, and exchange rate policy, as well as deteriorating relations between the U.S. and China.
 
Nonetheless, a loss of confidence in the dollar – in which U.S. bond yields rise as pressures on the dollar intensify – is unlikely. Dollar crises were common in the inflationary environment of the 1970s and 1980s. However, they have all but disappeared in the past three decades, which have been marked by chronic low inflation.
 
This does not mean that inflation will not accelerate in the future. Indeed, the Federal Reserve probably will tolerate a temporary overshoot of its 2% target if unemployment remains stubbornly high. But it would likely not tolerate a significant overshoot to say 4% or higher.
 
Finally, while some commentators have questioned whether the dollar’s status as the world’s reserve currency will be challenged, the likelihood is very low. The euro, which is the main alternative to the dollar, is based on an economic and political union that is less robust than the United States. In Asia, neither Japan or China are willing to accept the free flow of capital into and outside their borders, which is necessary to become the world’s leading currency.
 
Accordingly, the most likely outcome is that the dollar’s decline will continue to be benign for financial markets.   
nick sargen

Nick Sargen

Senior Economic Advisor
Nick is an international economist, global money manager, author, and contributor on television business news programs. He earned a PhD and MA from Stanford University and BA from UC, Berkeley.

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