The euro’s 5% gain against the US dollar in July has been predicated on the belief that the tide has turned for the once mighty greenback.  This week, I explore the ‘Dollar Downfall’ narrative in more detail, to try and understand whether it is constructed on solid foundations, or whether FX markets have gotten ahead of themselves.

In investing, narratives matter a lot.  But they are rarely cast in stone.

Pascal Blanque, Chief Investment Officer, Amundi Asset Management, August 3rd, 2020

If you want to make a million dollars just print a million dollars.

Kanye West, Rapper and Presidential Candidate, July 2020 (via Twitter)

Trouble’s coming, I don’t know when, but it’s coming.

Jim Chanos, US hedge fund manager, July 2020

The rally in EURUSD in July, which saw it soar from below 1.13 to over 1.19 (briefly) happened in the context of a dramatic shift in market sentiment surrounding the US dollar.  Back in March, during the height of the COVID-induced market panic, investors were desperate for dollars, lured by the safe-haven appeal of the deepest, most liquid asset market in the world.  A few weeks later and everything has changed – the dollar is now the pariah of the currency world, forsaken by all and undermined by a powerful narrative that the days of dollar dominance are over.

In his 2019 book ‘Narrative Economics’, Nobel Laureate Robert Shiller writes ‘an economic narrative is a contagious story that has the potential to change how people make economic decisions’ (emphasis added).  The ‘Dollar Downfall’ narrative is clearly contagious (euro net-long positions are now at their highest levels since record began, according to Bloomberg), but is it sustainable?  To answer this question, let us examine the three main pillars of this narrative.

 1) The US dollar’s status as the global reserve currency is under threat

This assertion is usually at the heart of the dollar bear case.  Based on the idea, articulated by plain-speaking 3rd party presidential candidate West, that any notion that the US is a sober steward of the world’s reserve currency has been trashed by the COVID crisis, it is argued that the days of the US dollar’s ‘exorbitant privilege’ are over.

As the Fed’s balance sheet has expanded from under 20% of GDP at the start of the year to about 33% today, with expectations that it will approach 50% by the end of the year, it is not hard to see why the market is nervous.  However, FX is a relative game, and it is hard to see why this alone should be a reason to sell the US dollar.  After all, the ECB’s balance sheet is even bigger on a like-for-like basis, now more than 60% of euro zone GDP following Q2’s GDP drop.  When looked at in the context of the FX market (and the US dollar’s dominant position therein), it is even harder to make the case that the US is in any way an outlier when it comes to monetary recklessness (see chart).

Chart 2: Central Bank Balance Size (current and expected) at July 2020

Source: Realvision.com

2) The US is mis-handling the pandemic (especially compared to Europe)

The second pillar of the dollar bear argument is that the US is having a much worse pandemic than Europe (and pretty much everywhere else).  As such, the conventional wisdom goes, the US economy will be damaged disproportionately, and the US dollar will decline. 

On one level, this assertion appears hard to argue against.  The US has seen a lot more COVID cases than Europe (around 5 million in the US versus 3 million in Europe) and, whether or not this is partially down to the fact the US is just better at testing, it is hard to dispute the fact that the European management of the crisis inspires more confidence than the American approach, which does seem to be more politicized and less transparent. 

However, when you look a little closer, things are not quite as straightforward as they might appear to be.  Yes, the US has more cases, but when it comes to mortality rates, there is actually very little to choose between the two.  Europe has about 1/3rd more deaths than the US to date and about 1/3rd more people. 

When it comes to the economic impact of the crisis (which you would think would be pretty important when evaluating the prospects for the dollar against the euro) the results are clear – the US is actually having a better crisis than Europe.  In Q1, as the COVID crisis began to have an effect, euro zone GDP contracted by 3.58%, compared to a decline of just (!) 1.26% in the US.  In Q2, while the US saw a dramatic GDP collapse of 9.49%, the euro zone’s economic decline was even more precipitous, shrinking by 12.11%.

3) Everything’s going to be fine (no need for ‘safe haven’ assets)

It is notable that the S&P 500 and EURUSD bottomed one day apart (March 19 / 20th) during the COVID market meltdown, before rallying in tandem.  Correlation does not imply causation, but there can be little doubt that the US dollar’s weakness is related to diminishing demand for safe-haven assets. 

This third pillar of the ‘Dollar Downfall’ narrative is the hardest to assess as it is based upon an unknowable assumption about future market developments, but there are three reasons to doubt its reliability.  First of all, it does seem to be in conflict with the idea that the US dollar’s reserve currency status is in jeopardy.  If things are really not so bad, then where will the impetus for such a seismic shift in the global financial system come from?  Secondly, as Jim Chanos implies above, it is increasingly hard to imagine that the much vaunted (and hoped for) V-shaped recovery will occur in the absence of a COVID vaccine / cure.  Finally, even if a rapid recovery is on the cards, why would that not just re-ignite the carry-driven US dollar bull market that has been in force since the beginning of 2018?

As we highlighted last week, EURUSD currently sits at an important technical level.  It has broken the 12-year downtrend, although it has yet to consolidate above this level.  While there are many reasons to doubt the legitimacy of the ‘Dollar Downfall’ narrative, this does not mean it can be ignored.  In our view, the recent EURUSD rally does look stretched, and we remain unconvinced by the case for extreme dollar bearishness.  However, as risk managers, we must remain alert to the possibility that we have reached a multi-year turning point for the dollar.     The key will be whether the ‘Dollar Downfall’ narrative, perhaps aided by rising US political risk heading into election season, can retain its contagious influence in the coming months.

Author: Kevin Lester