The US dollar is a tough one to turn

John Hardy
Head of FX Strategy

Summary:  The provision of Fed liquidity and the risk that this eventually results in inflation and more highly negative US real rates look enough to finally turn the USD lower.

Given the Powell Fed’s enormous turnaround in 2019 — in which it cut rates three times and launched a large-scale balance sheet growth to the tune of nearly $400 billion in Q4 — the US dollar is starting off 2020 in rather resilient shape. Many would have believed that the Fed’s turnaround over the course of 2019 and acceleration into year-end would have resulted in a far weaker US dollar. Especially considering that it has outpaced the easing from central banks elsewhere.

Why the US dollar has not weakened perhaps speaks to the residual strength in the US economy relative to global peers. While its manufacturing sector has suffered under the weight of Trump’s tariffs and a slowdown in US shale oil and gas development, the dominant services sector remained resilient and overall GDP growth averaged 2.4% for the first three quarters of 2019. Plus, Trump’s aggressive trade stance saw US trade deficits narrowing sharply in the second half of 2019, a difficult process to manage in a world that needs a steady drip feed of dollars since it is the global reserve and trade currency.  And finally, the market’s vigorous celebration of the Fed’s easier stance fed further enthusiasm for America’s world-dominating tech giants.

Many of the USD-positive drivers noted above look well entrenched as 2020 gets under way, but we still look for a low ceiling to what has effectively been a flat US dollar over the last 18 months. As the year wears on, we would look for a slowing US economy, a related chopping of US interest rates, ongoing Fed monetisation of US budget deficits and, not least, the US presidential election to weigh on the US dollar’s prospects. Especially if it appears a progressive Democrat like Bernie Sanders has any chance of becoming the nominee. 

The Fed’s actions to shore up liquidity in late 2019 are a result of the inability of the US financial system to absorb both the Fed’s quantitative tightening since 2018 in addition to the blitz of Treasury issuance required to finance the ballooning budget deficits in the wake of Trump’s tax cuts and spending increases. In a US recession scenario, these factors will accelerate further. Even without one, the provision of Fed liquidity and the risk that this eventually results in inflation and more highly negative US real rates look enough to finally turn the USD lower. 

JJH USD chart

Above chart shows the US dollar through the end of 2019 according to both the Fed’s broad, trade-weighted measure and the Bloomberg dollar index. Both show that the US dollar has done little over the last eighteen months, a timeframe that has included a final run-up and then crash in US treasury yields and a mirror-image dramatic semi-crash and then epic bull sprint in US equity markets. Outcomes are all about weighted probabilities, but we suspect 2020 either could see more of the same back and forth for the US dollar or, more likely, an eventual large inflection point lower for the global nominal measure of GDP as the Fed – and maybe even the US Treasury – is set to flood the world with US dollars. (Chart source: Bloomberg)

Elsewhere, we see the strong CNY at the beginning of the year as window dressing ahead of the US-China trade deal signed in mid-January. China may be playing a holding game on FX policy until it knows who its negotiating partner will be on trade on the other side of the US presidential election and we would suggest that the “phase one” trade deal is likely a phase one détente before hostilities resume down the road and the two largest economies continue to disengage. 

The broader situation across currencies is challenging as we start the year at near record complacency levels. Investors are celebrating the policy punchbowl and reaching for yield and the riskiest currencies and equities, rather than looking around at what is still a fairly sluggish growth outlook. We can all easily label it as crazy and unsustainable – but we’re not entirely sure what provides the pivot for this market and brings a return of reality. Will it be the Fed refusing to play ball with the moral hazard of monetising Trump deficits and underwriting the speculative frenzy, a new trade war, a Bernie Sanders presidency or markets simply collapsing under their own weight after a further parabolic run-up? We dare not say, but have a hard time believing the go-go environment as 2020 gets underway extends much past the end of Q1.  

The changing climate for currencies from here 

It is difficult to overlay individual currencies with climate change policy and environmental factors in an outlook, with one important exception this time around: the EU and the euro. EU policymakers have been the most aggressive in declaring a war on climate change and the intent to link pan-EU stimulus to the climate change agenda. 

This is the easiest political route to stimulus that is financed by all member states. The ECB, under its new, more politically charged leadership (President Christine Lagarde) has also explicitly stated it is looking for ways to support the climate agenda. In the short term, this may boost EU growth through new investment, but may also raise inflation. Interestingly, the possibility of a “carbon border tax” has been raised as part of the EU green deal, in which imports might be taxed on the carbon consumed in the production of a good. This is a whole new approach to protectionism relative to the Trump administration. 

While the EU economy might reap few rewards in the short term from stagflationary and possibly protectionist climate policy, the longer-term rewards will supposedly be reaped in increasing immunity to external fossil fuel reliance. It’s a risky gambit for the new EU leadership as we wait and watch whether Italy and CEE countries will play ball with these priorities.

How climate change and the policy environment affect currencies in coming years will depend on factors such as food security and the energy-intensity and energy-mix of GDP. This is particularly true of vulnerable emerging market economies, where rapidly rising food and/or energy import costs can more quickly impact growth. India is a case in point in terms of vulnerability to rising food prices and as an importer of the vast majority of its energy needs. 

Economies like the EU and Japan are quite well positioned on the surface, as they are among the most advanced developed economies, but with low energy-intensive GDP. The irony for both of those blocs, however, is that they are highly export dependent and big energy importers. The US is a food exporter and the shale revolution means it is almost self-reliant in energy – arguably a fortress economy safe from the risk of rising energy prices. Worst positioned of major economies in theory is China, which is less food- and energy-resource secure and is also rather export intensive, though much of its external investment in recent years has been aimed at reducing vulnerabilities.

Forewarned is forearmed: climate change and climate change policy will be felt the most in commodities, which have mostly been bumping along at multi-year lows in recent years. How and where commodity costs rise will become a major factor in currency movements from here.  

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