US dollar weakness won’t last. Signs show a turnaround is due

In an evolving situation, dollar bears have to decide if it still makes sense to buy another currency in preference to the dollar
While Chinese data may justify yuan strength versus the dollar, European data does not quite justify euro strength

Neal Kimberley

Published: 4:30pm, 25 Aug 2020

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US dollar bears have had a good run of late. The greenback has been on a downward trajectory against major currencies since March, as evidenced in the decline in the US dollar index. But nothing lasts forever. The US dollar is due for an improvement in its fortunes.

Last Wednesday saw the release of the minutes from the Federal Reserve’s July 28-29 meeting, minutes that stressed that the United States’ central bank still sees the outlook for US economic recovery as highly uncertain due to the continuing coronavirus pandemic.

The Fed also seems to be moving closer to finalising changes to its “Statement on Longer-Run Goals and Monetary Policy Strategy” to better reflect “fundamental changes in the [US] economy over the past decade – including generally lower levels of interest rates and persistent disinflationary pressures in the United States and abroad”.

Even without a pandemic, the market could conclude that such a recalibration of Fed strategy would crystallise the notion that the Fed plans to embrace looser monetary policy settings for longer than might historically be the case.

A banner against the eviction of renters hangs on a controlled-rent building in Washington, D.C., on August 9. In the Fed’s view, the outlook for US economic recovery is highly uncertain. Photo: AFP

So far, so dovish, but the reaction of the US dollar to the Fed minutes was revealing. Instead of slipping in the currency markets, the greenback rallied.

Going into the release of the Fed minutes, perhaps the market was too heavily short of US dollars. Certainly, market participants had gone in knowing that the latest data from the US Commodity Futures Trading Commission, for the week ending August 11, had shown the highest net short US dollar position since May 2011.

It’s also possible that the market had hoped the Fed would comment favourably on forms of yield curve control, or adopting caps or targets for Treasury yields to keep the cost of borrowing low. But the central bank gave the policy tool pretty short shrift. “Of those participants who discussed this option, most judged that yield caps and targets would likely provide only modest benefits in the current environment,” the minutes stated.

The Fed minutes just weren’t dovish enough to lead to further downward pressure on the value of the US dollar for a market that had already so heavily sold greenbacks.

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If so, that would also imply that if the US dollar is to continue on its downward trajectory, the market now needs new reasons to keep selling it. The foreign exchange markets would seem less inclined to unquestioningly assume that the US dollar remains on a weakening trend.

The market may also have to build into its calculations the possibility that, unless there is a dramatic worsening in the pandemic in the United States that is deemed to require a monetary policy response, the Fed might remain on hold until after the US presidential election in November.

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In addition, given that the spread of coronavirus in the US has been a key driver of Federal Reserve monetary policy action in recent months, action which has in turn arguably weighed on the value of the greenback, then the market may be sensitive to signs that the rise in infections is slowing.

Indeed, data from the US Centres for Disease Control and Prevention indicates that the number of new Covid-19 cases reported each day in the US since the beginning of the outbreak has begun to edge lower, with the seven-day average trending lower since the last week of July.

Additionally, as foreign exchange plays are always relative trades, US dollar bears also have to decide whether the calculation determining which currency to buy in preference to the greenback still makes sense. The case is easier to make when it is generally agreed the greenback is elevated, but progressively harder to make the further the dollar falls.

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It’s arguable that recent economic data from China still justifies some degree of yuan strength versus the dollar, but it’s more difficult to make a similar case for other major currencies, such as the euro, that have appreciated materially against the greenback in recent months. Perhaps tellingly, Friday’s close saw the US currency make its first weekly gain against the euro since mid-June.

Rising numbers of Covid-19 infections in Europe, evidenced in European Centre for Disease Prevention and Control statistics, and forward-looking US purchasing manager data that is currently more robust than that of the euro zone, are just two factors undermining the case for an even stronger euro versus the US dollar.

The US dollar has had a bad run in recent months but its fortunes may be turning.

Neal Kimberley is a commentator on macroeconomics and financial markets

This article appeared in the South China Morning Post print edition as: US dollar has had a bad run but its fortunes may be turning

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