Why the US dollar will remain on the comeback trail for many months

While the dollar outlook has been cloudy in the recent years, it is fighting back, thanks to tougher interest rate tightening expected from the Fed and a brighter political climate under US President Joe Biden

David Brown

Published: 10:00pm, 12 Jul 2021

Why you can trust SCMP

The dollar has had some pretty bad press in recent years, due to the Federal Reserve’s overly loose monetary policies, waning investor appeal and acute political worries under former US president Donald Trump. But, far from being on the skids, the dollar is fighting back, thanks to tougher interest rate tightening talk from the Fed and a much brighter political outlook under US President Joe Biden, with investors taking a more constructive view on the currency.

For investors worried about the rising threat of Covid-19 variants, the dollar also remains an ideal hedge against an uncertain world. The dollar’s credentials as the world’s major reserve currency, offering unbridled liquidity free from official interference, remain unparalleled and a big draw for investors.

It’s no surprise the US dollar index against a basket of major currencies recently hit a three-month high. The dollar should remain on the comeback trail for many more months to come.

The dollar has plenty of good support from the fundamentals too, including relative interest rate appeal, a solid economic growth advantage and strong capital inflows as international investors tap into the vibrant US stock market rally. The US economy stands to gain so much more thanks to Biden’s promise to get the economy back into better shape with an extra US$1.9 trillion of fiscal stimulus to get the job done.

It’s already boosting recovery expectations and reviving the US job market, generally perceived as a lagging indicator of economic well-being. US employment payrolls rose 850,000 in June, beating the 700,000 forecast, with the unemployment rate unexpectedly rising to 5.9 per cent from 5.8 per cent, a positive sign though, considering that more people were seeking work and now being counted among the jobless.

It’s no surprise that recovery expectations are riding high with the US growth rate expected to reach 6.9 per cent this year, according to forecasts from the Organisation for Economic Cooperation and Development. This compares more favourably than the 2021 growth forecasts of 4.3 per cent for the euro zone and 2.6 per cent for Japan, although China is expected to come through stronger at 8.5 per cent growth.

It’s why global investors remain so upbeat about the outlook for US equity markets this year as the US economy returns to better health. US growth momentum is expected to carry through to an above average 3.6 per cent expansion rate in 2022. Overseas demand for the US equity rally should exert major pulling power in the dollar’s favour this year.

US President Joe Biden speaks in Pittsburgh, Pennsylvania, on March 31. Biden unveiled a massive infrastructure plan aimed at modernising the country’s crumbling transport network, creating millions of jobs and enabling the country to out-compete China. Photo: AFP

With the US economy being pumped up on fiscal steroids, approaching optimum output potential and inflation alarm bells ringing, the Fed is doing the right thing in steering expectations towards early interest rate rises to quell any overheating risks and to take some of the speculative fizz out of effervescent stock markets. Encouraging market optimism is one thing, but the Fed is extremely reluctant to whip up irrational exuberance any further.

The odds of a Fed rate hike this year are rising but it may take a few years before US interest rates return to more normal levels in a 2-to-4 per cent range. At the moment US interest rate futures markets still seem cautious and looking for no more than 1 per cent of Fed tightening over the next year but this could quickly change.

In an overstimulated US economy, will inflation really be transitory?

Expectations about the speed of future rate moves will be the key to understanding the impact on currency perceptions. The European Central Bank and the Bank of Japan will find it less easy to tighten in the face of economic uncertainties and weaker recovery prospects, so it will be up to the Fed to lead the charge when the move towards higher interest rates finally gets into gear.

Europe and Japan will be happy to let the Fed take the initiative and enjoy some competitive edge for their exports as the dollar strengthens.

A stronger dollar would go down well with China too. Beijing may be happy to pay lip service to its dual circulation strategy in the short term and let the renminbi take the strain to boost China’s exporters.

Domestic-led strength may be the primary goal in the future but Beijing will want to tap into any vestige of export-led recovery to keep underlying gross domestic product growth above 6 per cent in the interim.

Keeping the renminbi trading above 6.50 yuan versus the dollar would definitely help maintain China’s competitive edge.

David Brown is the chief executive of New View Economics