There are no indications that the ongoing surge of the U.S. Dollar will lose its momentum anytime soon. At the end of 2019, Bloomberg forecasters optimistically projected that by the end of 2020, both EURUSD and GBPUSD will strengthen by circa 3% and 2% and hit the 1.15 and 1.35 levels respectively. However, reality has been far from expectation, and both currency pairs have dropped by 3.6% and 2% in 2020 and are trading at 1.08 and 1.29 respectively.

An understanding of some of the underlying factors at play, driving the strength of the dollar, and the risks to these factors in the near-term will be crucial in gauging the direction the dollar is headed and in anticipating potential reversals in this uptrend.

Chart 1: The surge of the U.S. Dollar Index
 

What factors have contributed to this U.S. Dollar uptrend?

Apart from the relative strength of the U.S. economy, three key forces are impacting the U.S. Dollar – expansionary fiscal policy, the Fed’s commitment to using ‘every scrap of policy space’ to drive economic growth and the greenback’s status as a safe-haven asset in a risk-off environment.

Fiscal Policy

The Trump era has been characterized by loose monetary policy. The fiscal deficit under Trump has been on the rise despite the US economy witnessing the longest economic expansion on record [Table 1].  The hallmark of Trump’s presidency was the tax overhaul in late 2017, with the Tax Cuts and Jobs Act (TCJA). In addition to permanently reducing the corporate tax rate, and on a go-forward basis, generally exempting the earnings of foreign subsidiaries of US firm from tax (even if the earnings are repatriated), the new law allowed firms to repatriate their undistributed and deferred post-1986 foreign income (estimated to be circa USD 2.6 trillion) at a reduced one-time mandatory repatriation tax. Since 2018, expectations of foreign earnings repatriation and more broadly, the government’s commitment to spur growth using Keynesian style fiscal stimulus has been a tailwind for the U.S. Dollar. 

The expansionary fiscal policy in the U.S. is a contrast to the Eurozone which has stuck to a broadly neutral fiscal policy for years. Additionally, the challenges that would be associated with coordinating fiscal policies among eurozone member nations can’t be overstated.

Table 1: The ballooning budget deficit in the US
Source: The Balance

Monetary policy

The Fed operates under a dual mandate from Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The tools that the Central Bank has used to achieve these objectives are:

A. Interest Rates

The USD rally started in July 2014, on the back of expectations of rate hikes, since the dot plat from the FOMC meeting in June 2014 indicated that members expected 3-4 rate hikes in 2015. The Federal Reserve ultimately embarked on a tightening cycle from late 2016-2018 while Europe was still in the grip of negative interest rates [Chart 2]. Although the BoE was also on a tightening cycle in 2018, interest rates in the US were the highest among the G4 economies, attracting capital flows in search of yield. The Fed’s hawkish stance until 2019 was a tailwind to the USD. Even as the Fed shifted stance with three ‘insurance’ cuts in 2019, contrary to expected behaviour, the dollar continued its upward trend.

B. Quantitative Easing

From 2008 to 2014 the Federal Reserve engaged in large scale purchases of bank debt, Treasury notes and mortgage-backed securities from banks with the objective of increasing the money supply in the economy, reducing borrowing costs, making more credit available and ultimately reviving economic growth. The jury is still out on the effectiveness of QE in meeting its objectives, however, if the barometer of the success of this asset purchase program, is the performance of the US stock market, then QE can be deemed a roaring success [Chart 3]. Foreign investors were keen on joining the S&P party and the equity capital flows increased the demand for the dollar [Chart 4].

Chart 2: Central Bank Policy Rates
Chart 3: Trends in the balance sheet growth of the Fed and the S&P index
Chart 4: Trends in the balance sheet growth of the Fed and the USD index

Safe-haven status

When the market was in risk-off mode with the uncertainty induced by the U.S. – China trade war, geopolitical tensions in the Middle East or more recently, the coronavirus outbreak, there was a renewed demand for the dollar because of its safe-haven status.

What are the risks to these factors?

Fiscal Policy

The biggest risk to the U.S. economy this year is the Presidential election. Currently, polls indicate that Sen. Sanders is leading the race to be the Democratic candidate for the upcoming elections. If elected, Sanders would seem to reverse Trump’s policies of lower taxes and deregulation and may erase some of the gains in the S&P and USD.

Across the pond, Eurozone finance ministers have been discussing ways to employ fiscal responses ‘for a more supportive stance at the aggregate level’, if downside risks, such as China’s coronavirus outbreak, materialize. If the tools of fiscal policy are employed successfully in the EU, it will be a tailwind for EURUSD.

Monetary policy

A. Interest Rates

Federal Reserve Chairman Powell told US lawmakers that, “Low rates are not really a choice anymore, they are a fact of reality.’ While the Fed has more room to cut compared to its G4 peers, the expectation is for the interest rate differential to shrink as the market is pricing in two more rate cuts by the Fed this year, and one by the BoE and ECB. The expectations of the market are at odds with Dallas Federal Reserve President, Robert Kaplan’s recent comments that the current federal funds rate is “roughly appropriate” and no more rate cuts are warranted. If the Fed is seen to be less dovish than expected over the course of the next few months, the USD is likely to continue its gains.

B. Quantitative Easing

Chairman Powell also told U.S. lawmakers that the Fed will be forced to use quantitative easing “aggressively” and will ensure “that we are using our tools as best we can, that we’ve explored every possible way to find every scrap of policy space, if you will, to be able to support the economy.” If the market views that the Fed is committed to using its monetary policy tools to stimulate the economy, it will support asset prices and ultimately attract capital flows into the U.S., boosting the dollar.

Safe-haven status

The dollar has proved to be the dominant safe-haven asset, slamming the yen, in the current risk-off state as the market grapples with the economic risks at the back of the coronavirus outbreak. The dollar index is up to the highest level since 2016 and the greenback’s safe-haven status is likely to push the dollar higher if the impact of the outbreak is more severe than estimated.

Overall, we continue to expect that the dollar bull trend has further to run, certainly in the short term, unless the domestic political risks significantly increase.

Author: Chris Jerome