For the past eight years the US dollar (USD) has been on an upward trend, rising substantially against most of its peers. Support came from three sources:
1) An improving US fiscal situation from 2010 to 2016.
2) Substantially tighter monetary policy since 2016.
3) Stronger US growth than in Europe and Japan, especially in 2011-13, and since 2017.
The first of the three sources of support for the dollar was undercut in 2017 when the US budget deficit expanded from 2.2% of GDP in 2016 to 4.7% by mid-2019. Additionally, despite recent protectionist measures, the US trade deficit has expanded, rising from 2.5% to 3.0% of GDP. This has taken the so-called “twin deficits” from 4.7% to 7.7% of GDP.
For the past three decades smaller twin deficits have usually been followed by a stronger USD – often with a lag of 1 to 2 years. Meanwhile, expanding deficits have often been followed by a much weaker USD, often with a much shorter lag (Fig.1).
This time around, USD has resisted a major selloff largely because of Fed tightening and the boost to growth from the tax cuts that took effect in 2018.
The Fed hiked rates four times in 2018, bringing the total number of increases to nine in the current cycle that began at the end of 2015. No other central bank has raised rates anywhere near as often. While the Bank of Canada and the Bank of England have dipped their toes in rate hikes, most other central banks including the European Central Bank (ECB), the Swiss National Bank (SNB) and the Bank of Japan (BOJ) have had easy monetary policy (Fig.2). Some central banks such as the Reserve Bank of Australia (RBA) and the People’s Bank of China (PBOC) have been actively easing monetary policy.
The market is pricing that the Fed will cut interest rates up to four times over the next year (Fig.3) but, so far, the Fed itself hasn’t committed to such a drastic policy action, only opening the door to a possible rate cut. Nevertheless, US monetary policy probably will no longer be a source of support for the USD in the year ahead, unless there is a dramatic change in rate expectations.
Further, fear of a slowdown in US growth is a large part of the reason why fixed income markets have come to price such a dramatic change in Fed policy. So far, the evidence of an economic slowdown has been mixed, but the ratios of US leading-to-coincident and leading-to-lagging indicators have been pointing to a moderation in the pace of US growth (Fig.4). If the US expansion slows, it will go a long way towards closing the growth gap between the US and the already struggling economies in Europe, and Japan.
Finally, what should be of greatest concern to anyone long USD is the possibility that the Fed might keep rates too high for too long that results in an economic downturn that subsequently requires the return to near-zero rates. During recessions, the US budget deficit expands by about 4% of GDP on average – although the trade deficit usually shrinks a bit. Under that circumstance, USD would be faced with rates stuck near zero, huge twin deficits (mainly from the budget side) and no growth gap with the rest of the world.
So, if USD suffers another decade-long bear market in the 2020s, like it did from 2002 until 2011, who benefits? Which currencies would be most likely to go higher?
Here is our ranking of the likely “beneficiaries” of any dollar weakness (and we put beneficiaries in quotes because a stronger currency isn’t necessarily good for the economy).