Forecasting the dollar in a post-pandemic world

Economics The Real Economy

The probability of the economy and financial markets returning to their pre-pandemic state is quite low. Nowhere is this more evident than in trying to estimate valuations of the U.S. dollar. Despite the robust rebound in consumer demand, a sluggish external sector and pandemic-induced economic distortions add a worrisome element to the breadth of the recovery and to the value of the dollar.

There is good reason to think that the United States will be the first of the developed economies to close its output gap, with increased demand in coming months that will turn recovery into economic expansion.

We are anticipating the highest rates of growth in gross domestic product since the 1980s, supporting 10-year interest rates reaching upward to 1.9% over the course of the year. And one must note that those high nominal interest rates must be coupled with real interest rates that are negative in the United States and likely to grow more so in the coming months.

For this reason, we expect that the value of the greenback will experience notable volatility with modest downward pressure, causing the dollar to decline in value against major trading currencies.

MIDDLE MARKET INSIGHT: For middle market firms with significant exposure to the Canadian dollar and Mexican peso, downward pressure on the greenback implies modestly higher prices on the margin.

For middle market firms with significant exposure to the Canadian dollar and Mexican peso, this implies modestly higher prices on the margin.

Yet there is a lot of ground to cover before we can declare global victory over the pandemic. There is still too much uncertainty regarding the rapid spread of the virus and its variants in India, South Africa and Brazil, and the risk of spread to the unvaccinated American public.

In addition, long-term scarring to the U.S. labor force; the lack of immigration and a low birthrate; and the loss of U.S. market share during the trade war might prove to be unrecoverable in the short term, and difficult to mend over the long haul.

In the next sections, we’ll outline the difficulty in forecasting the dollar in an environment in which the efficiency of the global supply chain has undeniably become part of commercial life and the United States is no longer the only major exporter to the world. And we’ll discuss the efficacy of the debate over dollar strength and the economy, branding that discussion more as a holdover from an earlier time.

MIDDLE MARKET INSIGHT: Though U.S. imports appear to be making up for the dearth of consumer spending during the pandemic shutdown, exports of goods remain underwater.

Relative growth and the dollar

Given expectations by international economics officials that the U.S. economy will be the first among developed economies to expand, doesn’t that imply that the dollar will be stronger?

That assumption is not necessarily true. The value of the dollar, like any other commodity, depends on the demand for dollar-based assets–both financial and physical–and the transactional use of the dollar in commercial activity. The demand for dollars depends on a host of factors, both domestic and foreign. There have been several recent examples where the relationship between domestic growth and the value of the dollar has been inconsistent.

The value of the dollar will be determined by its use as a vehicle of commerical exchange and by the demand for U.S. goods and ideas. The foundation of that demand will be determined by the stability of the economy and society, and the laws and institutions that guarantee that stability.

For instance, the U.S. economy took off during the mid-1990s as the digital age began. Investment was pouring into the technology sector, and the dollar appreciated versus the deutschmark, which was the European benchmark at the time. That era of dollar strength ended with the thud of the 2001 bust.

The bust happened at the same time as anxiety over European unification and its single currency were overcome, followed shortly by the attacks on the United States and the onset of wars in Iraq and Afghanistan. The dollar weakened versus the euro until the 2008-09 financial crisis.

With the Federal Reserve cementing its role as lender of last resort to the world during the financial crisis, the dollar started a period of appreciation versus the euro despite the reluctance of American fiscal authorities to juice the tepid economic recovery from the Great Recession. To be fair, some of the dollar’s early strength was because of the ongoing saga of the European debt crisis, which was more than enough to scare off investors.

In the second half of the latest decade, Germany’s economy was growing at a five-year average rate of only 1.6%, having been dragged into the U.S. trade war and the global manufacturing recession. From 2015, the U.S. economy grew at an average rate of 2.5% before slipping a bit in the last quarter of 2019.

Yet despite the attractiveness of U.S. equity returns, the euro range-traded during 2015-16 before entering a jagged uptrend versus the dollar. The euro has appreciated by 18% since January 2017 and then in the latest episode by 14% since the pandemic shutdown and equity market collapse of March 2020.

US dollar/euro exchange rate
chart - dollar - TRE 06/21 - chart 1

Given the randomness of event risk, can we say anything about the relative growth of the U.S. and German economies and the direction of the dollar from here?

We show the growing interconnectedness of the German and U.S. economies and the casual-at-best relationship between Germany-U.S. growth differentials and the euro exchange rate in recent years.

What these figures suggest is that as the developed economies become more in sync in terms of monetary policy and as cross-border commerce grows, the exchange rate is more likely to mean-revert within a narrowing range. It will operate more as an agent of exchange and less as a component return on investment.

The euro’s center of gravity has been $1.20 for decades, and as political and economic alliances are rebuilt, mean-reverting seems to be the opening bid on the exchange rate’s direction.

US and germany real GDP growth
chart - dollar - TRE 06/21 - chart 2
Germany - US real GDP growth differential and the euro
chart - dollar - TRE 06/21 - chart 3

Real and nominal interest rates and the dollar

Given the expectations that the U.S. economy will support higher interest rates–and given that nominal German interest rates are negative–doesn’t that imply that the dollar will be stronger?

It’s not that simple anymore. First, a little history on how we got here.

During the first decades of free-floating exchange rates –starting in 1973 when President Richard Nixon ended the dollar’s convertibility to gold–the direction of the dollar could be determined by the real (inflation-adjusted) interest-rate differential between trading partners.

The currencies of nations that could support higher real interest rates relative to their trading partners would appreciate on trend. The idea was that the nations with the highest available inflation-adjusted return on investment would attract the highest demand for their assets.

That relationship became less reliable in the 1990s as the United States lost its dominance in international trade as Asian economies produced consumer goods and then intermediate goods along a growing global supply chain.

But the most important factor in the demise of the relationship was the adoption of inflation targeting among the world’s central banks. This policy damped inflation as interest rates among the developed economies converged at extremely low levels. There was no longer enough space between foreign and domestic interest rates to make a difference where you put your money.

The result was an increase in savings, a flood of cash sloshing around the globe, the decline of U.S. investment, and U.S. relinquishment of industrial dominance. Starting in 2006, the trends in German-U.S. real interest rate differentials and the euro were at times moving in opposite directions, or, at best, moving together.

In some respects, the global savings glut remains the biggest force influencing financial markets including the valuation of the dollar and other major trading currencies.

It’s hard to argue that German fixed-income assets will draw much attention from foreign investors. The yield on 10-year government bonds approached zero by 2015, and then turned negative and stayed there. U.S. bond yields are low, but positive, and are being pushed by expectations for increased growth and normal levels of inflation.

In a vacuum, it would be difficult to argue that global investors would choose a negative return over the positive return of a guaranteed U.S. security.

So based on nominal yields, we could mark this on the plus side for the dollar. But with U.S. real interest rates becoming more negative because of the jump in inflation and with nominal U.S. yields suppressed by monetary policy, it’s a risky call.  

Real 10-year interest-rate spreads and the dollar
chart - dollar - TRE 06/21 - chart 4
Nominal US and German 10-year bond yields
chart - dollar - TRE 06/21 - chart 5

The external sector and the dollar

There are several sources of demand for dollar-denominated assets. The first is the demand for U.S. goods and services, which includes everything from exports of soybeans to foreign demand for U.S. movies. Second is the demand for dollar-based financial assets, which includes everything from technology ETFs to Treasury bonds. Third would be demand for foreign direct investments in U.S. shopping malls and businesses.

Foreign trade

After peaking in May 2018, U.S. exports have been in decline and have yet to recover their lost ground. Though U.S. imports appear to be making up for the dearth of consumer spending during the pandemic shutdown, exports of goods remain underwater. The decrease in U.S. exports coincides with the onset of the U.S. trade war, but the United States is not the only nation affected, and the loss of market share began 20 years ago.

According to International Monetary Fund data, the U.S. share of global exports has been dropping on trend for two decades, from a 19% share in 2000 to a 13% share in 2021. Euro-area exports have also fallen, from a 29% share in 2000 to 23% in 2021. Where have all the exports gone?

The era in the mid to late-1990s led to the development of advanced logistics and to a positive shock for the low-labor-cost centers of production in the emerging markets. The share of global exports produced in the advanced economies began to shrink from 78% in 2000 to 61% in 2001. The share of exports produced in the emerging economies increased from 23% to 39%.

US exports and imports during recessions
chart - dollar - TRE 06/21 - chart 6
US and euro area share of global exports
chart - dollar - TRE 06/21 - chart 7
advanced and emerging economy share of global exports
chart - dollar - TRE 06/21 - chart 8

Nevertheless, the decrease of U.S. exports since 2018 is disconcerting as is the 2013-21 deterioration of the U.S. current account balance, which is dominated by the trade of goods but includes services, which are vital for an economy now dependent on thought.

Again, there was a striking relationship between the current account and the direction of the dollar from 2000 to 2006. But that ended with the sketchy investments during the housing boom, and continued to lose some of its luster after the financial crisis.

Both the current account and the dollar deteriorated during the pandemic, and the loss of U.S. market share is likely to continue without the United States' willingness to undertake significant investments in the intellectual and physical infrastructure necessary to sustain a modern economy based on information and digital technologies.

US current account balance and the dollar index
chart - dollar - TRE 06/21 - chart 9

Foreign portfolio investment

The Treasury tracks purchases of net foreign portfolio investment; that is purchases less sales of U.S. long-term financial assets by foreigners. From the 1990s to the end of the housing boom in 2007, net purchases increased along with the dollar, with foreign investors earning the guaranteed rate of return of U.S. Treasury notes and bonds augmented by a positive currency return component on their investment.

The financial crisis brought that era to an end. The sluggish economic recovery after the Great Recession required an accommodative monetary-policy response, and the extremely low interest rates and sluggish recovery of the dollar were no longer an attractive investment for foreign investors.

Recent months have been the most encouraging since the dry spell that began with the self-exile of the U.S. from international relations and trade and the subsequent monetary response from the Fed and then the pandemic. Long-term U.S. interest rates are increasing again along with employment and growth, and net long-term portfolio purchases by foreign investors are moving higher. That should support the dollar

net foreign long-term portfolio investment in the US before and after recessions
chart - dollar - TRE 06/21 - chart 10

Foreign direct investment

Foreign direct investment has dropped in each of the past three recessions (and the unofficial 2014-15 mini-recession brought on by the collapse of commodity prices). Foreign direct investment has grown in recent quarters, but remains roughly 13% lower than year-end 2019 and 18% below mid-2018 levels when the tariffs took hold.

History suggests that there is a lag before the direct investment gap is closed after a recession, with foreign investors taking a pause while evidence of a sustained recovery materializes. That would suggest a delayed response by the dollar as well.

Foreign direct investment in the US before and after recessions
Foreign direct investment in the US before and after recessions

The strength of the argument over the strength of the dollar

The recent recession and recovery have been unusual, and the ensuing expansion will depend on the ability to vaccinate the U.S. public as well as the global population. There are no guarantees. But we do think the United States (and the U.K.) will be vaccinated earlier than other major economies and that U.S. monetary policy will be prudently allowed to adjust when circumstances allow.

With that in mind, and with the difficulty of predicting the dollar, we might nevertheless expect the dollar to appreciate as soon as 10-year bond yields are no longer tethered by Federal Reserve purchases of long-term assets and until the Fed begins to move its policy rate off the zero lower bound. Raising the federal funds rate will at some point cause investors to expect slower growth, prompting an opposite and transitory bond market reaction.

We might expect the dollar to appreciate as soon as 10-year Treasury bond yields are no longer tethered by Federal Reserve’s accommodative monetary policies.

We do not expect the Fed to start discussing the tapering of its $120 billion in monthly asset purchases until later this year, nor do we expect it will start the actual reduction until 2022 and increase its policy rate until early 2023. For this reason, the next year will most likely be defined by volatility and downward pressure on the greenback against the major trading currencies.

The lack of exports is unlikely to be resolved overnight, however, and that would temper any dollar gains. Our trading partners will find that the time and cost of realigning their supply chain back to U.S. suppliers may not be worth the effort, and at some point, U.S. exporters will be forced to turn their energy to other endeavors. That is the cost of poorly conceived policy, and every effort should be made (or has been made) to reverse those decisions.

These are short-term issues for the dollar. If one believes in the efficiency of the market, and if international cooperation and development are allowed to produce the best outcomes, then movements of the dollar become part of business. There are hedging techniques that can mollify the risk of currency exposure, and any entity that operates within the global supply chain–and we all do–should weigh the cost of hedging versus the risk of currency losses.

Overall, arguments over the strength of the dollar belong to another era. We no longer operate under a self-defeating mercantilist system or use currency manipulation to make our products more attractive than our trading rivals.

Rather, as economies become integrated, currencies act as a medium of exchange and neither a store of value nor a measure of the economy’s direction.

The value of the dollar will be determined by its use as a vehicle of commercial exchange and by the demand for U.S. goods and ideas. The foundation of that demand will be determined by the stability of the economy and society, and the laws and institutions that guarantee that stability.

So it might be a waste of time to argue that some industries need the protection of a weak dollar, or that a certain policy will result in a weak or strong dollar. In a free market, the value of a free-floating exchange rate is out of our hands.

If an industry is deemed to be essential but some other country holds a competitive advantage (for instance, producing protective wear during a pandemic), then it makes sense that the government stockpile those goods (as was the case for Finland before the pandemic) or to operate those industries as public utilities to ensure sufficient domestic production.

The takeaway

The foolishness of thinking that we live in a zero-sum world of competing economies is in full display. Protectionist tactics brought the global manufacturing sector to its knees and to no one’s benefit before the pandemic. And as a result of those tactics, some sectors of the U.S. economy have quite possibly lost market share.

It bears repeating: The dollar’s value will be determined by the strength of our ideas not by zero-sum protectionist policies that are inward-looking and insular.

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