The Battle of Wills over the US Dollar
Markets are having a big debate over how much further to drive down the Dollar
For the first time in many years, the Dollar is experiencing a sustained fall. Markets - and people - aren’t used to seeing that, so this is giving rise to all kinds of hyperbole about what’s happening. In today’s post, I lay out the three hypotheses markets are debating. It’s this debate that will determine how much further the Dollar falls.
But before I go into the details on what markets are thinking, let me put things in perspective. The Dollar against other advanced economies (often called the G10) is down four percent since the election (black line), which is hardly cataclysmic. The Dollar against a basket of EM currencies - I exclude China and Russia because these currencies are heavily manipulated - is flat since November 5 (blue line), again hardly cataclysmic. So - whatever headlines you read - it’s not like things are falling apart for the Dollar. In the big picture, the Dollar is relatively stable and - over a longer horizon - still exceptionally strong.
That said, markets are debating Dollar direction with a ferocity I haven’t seen in many years. There’s three hypotheses currently in play:
First, there’s a camp that thinks the Dollar will fall further, but only temporarily as a short-term, cyclical unwind of US “exceptionalism” inflows, which I wrote about here. This is the most benign Dollar weakness view, because it sees further Dollar depreciation as the usual ebb and flow in global currency markets.
Second, there’s a camp that thinks a bigger shift is underway. Before the 2008 crisis and immediately after, the Dollar would fall whenever US data were strong (in contrast to recent years, when strong US data pushed up the Dollar). That correlation - Dollar down on strong US data - reflected a market view that the Fed was more dovish than other central banks, keeping policy rates low even in the face of strong data. This Dollar weakness view is less benign, because it goes in the direction of a loss of Fed independence, which markets are very fearful of.
Third, there’s a camp that thinks recent policy chaos in Washington will lead to a loss of reserve currency status. This is by far the least benign view, because this would come with substantially higher interest rates, which would choke growth and necessitate painful adjustments in fiscal policy. Reserve currency status was built over many decades, so - however chaotic recent months have been - I don’t think this is remotely in play, not least since there’s TINA (there is no alternative).
So where are we in the Dollar weakness debate? In my view, the debate is currently oscillating between the first and second hypotheses, i.e. the debate is between a camp that expects further Dollar weakness due to a cyclical re-rating of the US economy and a camp that worries about a loss of Fed independence, which would change more fundamentally how the Dollar trades. As far as I can tell, loss of reserve currency status is no longer being actively debated, at least not at present.
As I said above, the debate over Dollar direction is being had with a ferocity I haven’t seen in a long time. The debate has become highly emotional, which I think is a signal that the Dollar is now oversold. In the end, fundamentals only evolve slowly. Markets - and emotions - have gotten ahead of themselves. My underlying view is that the Dollar is in a multi-decade strengthening cycle that’s far from over.
I fail to understand Robin Brook’s point #2, to which he ascribes the most importance for the current behavior of the US currency. This is not the first time he has pointed out the negative correlation between the dollar’s exchange rate value and the strength/weakness of US data. His reference to the period immediately following the GFC confuses me still further, not the actual phenomenon of the correlation but the economic logic for it.
Why would the dovish Fed then (and now) be good for the US currency? And vice versa? Is this a liquidity argument, that not just low rates but the full panoply of facilities that the Fed makes available that bolster risk-asset markets and hence keep demand for the dollar strong? And a hawkish Fed will crimp these valuations and so trigger a flight out of dollars? Please explain.
I see it very similarly. In my view, the Dollar has recently come under pressure due to political chaos, which has led to a temporary loss of confidence—particularly among international investors. That explains at least part of the recent weakness.
However, I see this more as a short-term overreaction. Once the political situation calms down—which it usually does at some point—sentiment should normalize. In that kind of environment, there’s a good chance we’ll see a rebound in the Dollar. The latest news out of China could even serve as the trigger for that reversal.
What’s also interesting from a sentiment perspective is that retail positioning is currently very bearish on the Dollar. That, too, often acts as a contrarian signal.