One of the hallmarks of the pandemic era of global finance has been the relative strength of the U.S. dollar despite the trillions of dollars put forward as fiscal aid to mitigate the economic damage.
The greenback has increased 3.89% this year, but we think that strength is at risk.
The greenback has increased 3.89% this year using the Fed’s broad trade-weighted index as our benchmark. Because of growing risks around the domestic management of the pandemic and increasing uncertainty around U.S. fiscal policy, we think that strength is at risk.
Traditionally, the U.S. economy and the dollar tend to be leaders out of global economic downturns. But because of challenges inside the U.S. in addressing the pandemic, it looks as if the European Union will most likely take that mantle of economic leadership following this downturn.
We anticipate that this recession could very well be the exception to the rule with respect to estimating the direction of the dollar’s valuation.
Instead of leading the rest of the world out of a global downturn, the next U.S. recovery could very well lag the global business cycle, should the spread of the novel coronavirus continue into the interior of the United States, or should resistance to vaccination delay the resumption of normal life and – even more damaging — affect the potential for growth.
In ordinary business cycles, the U.S. economy has tended to lead the rest of the world out recession, with the increase in U.S. real interest rates relative to other countries resulting in higher interest-rate differentials moving in the dollar’s favor.
Recall that the dollar is like any other commodity; its value rises as demand for dollar-based assets (and securities) increases, and its value declines as the demand for those assets declines.
As the figure below shows, the dollar’s value increased during the 1980s double dip recession, and by the end of the early 1990s recession, the 2001 dot.com recession, and the 2007-9 financial crisis and subsequent Great Recession.
In the current episode, the dollar was moving higher at a modest rate, most likely because of the demand for higher returns in the U.S. equity market. Since March, however, the dollar has moved lower as uncertainty over policies to limit the coronavirus took center stage in the investment decision process.
In the short run – in theory and experience — as the search for yield increases during a global downturn, international funds (also known as “hot money”) will tend to move toward the higher returns of dollar-based securities relative to other currencies, assuming, of course, that the U.S. business cycle is leading the foreign cycle.
Higher returns on U.S. securities would develop out of an expansive fiscal policy and its encouragement of investment and consumer spending and the impact of overall economic growth on employment opportunities and wages.
In addition, the dollar is likely to benefit from safe-haven demand, with the value of dollar considered to be secured by the U.S. legal system and expectations of an appropriate response by the Federal Reserve and the government policy to aberrations in the business cycle.
But given the decline in nominal interest rates to zero and the reality of real negative interest rates all the way out along the curve until 30 years, global investors have recently begin to damp down the value of the dollar, which had declined 5.52% since March 23.
In the long-run — and we’re talking about the very long run — prolonged government spending and outsized increases in debt would be expected to lead to increased inflation and therefore a decrease in real interest rates and ultimately downward pressure on the dollar.
One cannot point to an instance where U.S. fiscal spending was overdone or ill-advised, except for the 2017 tax cuts that produced little in the way of investment or long-term growth. Instead, that late-cycle injection of cash resulted in stock buybacks, inflated spending by upper-income cohorts and an inflated equity market.
Foreign long-term investment
With the defeat of inflation and the worldwide compression of interest rates since the late 1970s, we should also look to measures of foreign long-term investment trends as indicative of potential dollar strength.
Foreign direct investment into the U.S. peaked or plateaued in early 2018 and has been in rapid decline during the pandemic.
In the first figure below, we show the trends in foreign direct investment into the United States since 1996, with foreign direct investment declining during the 2001 and 2007-9 recessions and then again in response to the 2020 coronavirus pandemic.
Of note, though, is that foreign direct investment into the U.S. peaked or plateaued in early 2018 and has been in rapid decline during the pandemic. Clearly, part of that rapid decline in this latest episode is because of the shutdown of the global economy and the withdrawal of investment funds.
The second figure perhaps indicates the reluctance of foreign investors to purchase U.S. long-term securities, given the implosion of mortgage lending that led to the 2007-9 financial crisis. Instead of increasing during the long recovery since 2010, net long-term portfolio investment has trended downward in fits and starts, before dropping rapidly with the onset of the U.S. trade war and then into the pandemic outbreak this year.
The existence of downtrends in long-term foreign investment implies the potential struggle to attract additional foreign investment once a sustainable U.S. recovery begins.
Long-term investment requires perceptions of policies that provide a stable environment for domestic consumption and trade. The inability to control the virus suggests otherwise, with reduced foreign investment knocking out a leg of support for the dollar.
Closing thoughts on a strong dollar
We no longer live in a mercantilist world, where countries devalue their currency to promote exports. That’s a zero-sum game. So calls for the Federal Reserve to further lower interest rates or experiment with negative nominal rates to weaken the dollar might not only be inappropriate, considering the role of the U.S. dollar in international trade, but also self-defeating.
The strength of the dollar coming out of economic downturns — as we saw in the first figure above — is a healthy sign that the U.S. economy is recovering, and that increased demand for foreign products via the stronger dollar can be the catalyst for international growth.
After all, increased growth in foreign countries should result in increased demand for U.S. products. Unfortunately, for now, the value of the dollar may be directly and indirectly influenced by public health policy.
Until that policy changes, the value of the dollar will be a risk relative to the euro and the other major trading currencies.
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