Improving risk appetite in a global sense has meant that the greenback has lost the support of safe-haven flows, resulting in some of the most rapid depreciation in the currency seen in decades.
Looking ahead, we believe several of these factors will prove persistent, contributing to a secular break lower for the US dollar and a return to pre-2015 dynamics against G10 currencies.
A Secular Break Lower for the Dollar?
EURUSD comprises 57.6% of the DXY index.
Previous medium-term dynamics for the greenback have been described by some analysts as being a “dollar smile” of US dollar strength in the initial stages of a crisis amid weak US and global macro prospects, followed by weakness during synchronised recovery, and then another wave of dollar strength as the US economy outperforms and Fed policy turns hawkish. In this outlook, we argue this recovery will instead be characterised by a dollar smirk. Although dollar strength characterised the early stages of the crisis, we believe the recovery will see the US dollar remain weak during the recovery as the domestic economy lags and the FOMC’s reaction function is significantly more dovish.
In our view, the most decisive factor for a weaker dollar in the medium term will be a slower US recovery, marked by a more dovish FOMC reaction function than previous medium-term cycles. US growth is likely to lag peer economies meaningfully over the next 6-12 months, due to a significantly more persistent COVID-19 outbreak and greater “scarring” to the economy as a result. The FOMC, in the meantime, is increasingly clear about its intention to not only enact historic stimulus to respond to the initial economic shock, but also keep rates lower for longer. The Fed is likely to formally revise its forward guidance and inflation targeting strategy. As a result, a future recovery in US growth or even a period of economic outperformance is unlikely to result in lasting or significant appreciation in the dollar.
USD Smile, USD smirk
A QUICK CAVEAT: USD REMAINS A HAVEN AND RISK APPETITE MAY PROVE FRAGILE
There has been a lot of discussion about the end of the dollar’s status as a reserve asset – but reports of the greenback’s demise as a safe haven may prove greatly exaggerated. US assets continue to comprise the vast bulk of central bank reserves, and as March proved, US dollar liquidity remains king during serious periods of demand for haven assets. Over a 12-month horizon, we argue that the two decisive factors for USD weakness will be a more dovish FOMC reaction function and a lagging economic recovery in the US, due to the uniquely bad domestic coronavirus outbreak. However, the pace of July’s moves caught us by surprise; against many currencies, the dollar has already depreciated past our previous 6 or even 12-month targets. Although we retain a bearish bias on the dollar both in the short and medium-term, we take note of the fact that this is a crowded trade – institutional forecasts are overwhelmingly in favour of further dollar forecasts, and positioning on most major currencies is short on the dollar. In the short run, several factors could slow or delay further depreciation in the greenback. Over the 6-month horizon, risk appetite will be challenged by global developments in the COVID pandemic, and the US election will contribute to high uncertainty and volatility. As such, significant potential remains for an abrupt dollar rally in the short run, especially considering how stretched positioning remains against several major currencies, notably the euro.
EUR Positioning reaches record net longs
MACRO & MONETARY SUMMARY
Like many other developed economies, the US experienced a historic contraction in economic activity in the second quarter of 2020, due to aggressive measures aimed at halting the exponential worsening of the COVID-19 pandemic. Unlike many peer economies, the US did not succeed in doing so during Q2. Localised outbreaks in several states continue to worsen by several measures, and there is a significant risk that restrictions on economic activity may have to be re-tightened. Such a development would threaten the substantial economic bounce that is already occurring after the Q2 contraction. The core question for the short-term US outlook is if it will be possible to manage the pandemic using less costly measures such as mask-wearing, while allowing effective reopening of the majority of the economy, as was possible in several other countries. In the medium and long term, the most important question is how significant the “scarring” from Q2 and Q3 will prove.
Our key views and judgements for the US economy and monetary policy are:
- The second wave of COVID-19 cases in the US will cause a significant drag on Q3 growth. The risks remain tilted severely to the downside due to the possibility of local healthcare systems reaching saturation, resulting in further economically costly restrictions.
- The extended nature of the crisis in the US risks more severe economic “scarring” from labour market damage, and damage to consumer and business sentiment.
- The FOMC will use forward guidance, asset purchases, and possibly a change to its inflation targeting goal to enact a further, substantial loosening in monetary policy in Q3 and Q4, driving real US yields lower.
- In the longer run, the Fed’s reaction function will be significantly less responsive to upside inflation risk. This will mean an asymmetrical “dollar smile” where improvements in the local economy are not as conducive to US dollar strength as in previous recoveries.
US MACRO & COVID-19 AT A GLANCE
The US economy contracted by around 33% in the second quarter on an annualised basis. Following this historic contraction, which occurred largely during March and April, economic activity began to increase again as early as May due to the rapid lifting of lockdown measures. The current vintage of traditional “hard” economic data and “soft” survey data generally suggest a story of rapid recovery from the lows of Q2. Of the roughly 22 million workers that were made either temporarily or permanently unemployed in March and April, 7.5m were rehired in May and June. Survey-based activity indicators such as purchasing managers’ indices saw solid improvements in June, with ISM’s indices rising into expansionary territory. Retail sales rose 18.2% in May and 7.5% in June, following a 14.7% contraction in April.
Based on these official sources, a plurality of economic forecasters initially expected a sharp rebound in the pace of growth in the second quarter. In recent weeks, however, the outlook has become considerably more complicated by the “second wave” of virus cases and the re-tightening of pandemic control measures in a significant minority of states. Put together, the ten states that have recently undertaken significant tightening represent 39% of the US population. When combined with those areas still under some partial restrictions, a significant part of the US population remains under some form of restriction on venues for consumer spending.
Following July’s tightening of restrictions in affected states, there have been tentative signs of case count growth beginning to stabilise in several key states, notably Texas and Florida. Discerning the cause of this decline is difficult, but it seems safe to say that restrictions on indoor venues and increased mask-wearing probably contributed. However, even if exponential growth in local outbreaks has been stopped by these measures, rising hospitalisation rates suggest that the measures may need to either be expanded or extended to achieve a sufficient fall in the rate of case increase to avoid saturation of local health systems. This places the focus on consumer spending – which usually accounts for two-thirds of US GDP – as a serious drag on growth in the third quarter.
Daily case count stabilise, but remain high in key states….
Daily cases, 7-day Moving Averages
….threatening to stretch health resources
Hospital bed occupancy, 7-day Moving Averages
THE SECOND WAVE DRAGS ON Q3 AND BEYOND
Although hard data and surveys suggest that the economy is on track for a rapid bounce in Q3, the second wave of coronavirus infections and state-level restrictions to combat it is likely to carry a significant cost for the US economy in Q3 and beyond. This is illustrated by a variety of alternative data such as Apple mobility, Opentable bookings, and Homebase, which show consumer activity growth slowing in July. These alternative data, together with the general hospitality and services focus of the additional restrictions that are currently being favoured as marginal control measures, suggest that consumer behaviour will be slow to continue its recovery.
Alternative data suggest flattening in consumer spending growth
The size of this effect is anyone’s guess, however. Forecasts submitted to Bloomberg for Private Consumption in Q3 show a wide variation and little consensus: a range from +14.1% to 30.2% covers only half of the 63 forecasts submitted to Bloomberg. The wide dispersion of possible consumption outcomes drives the bulk of uncertainty about the headline GDP number for Q3, with submissions similarly widely distributed around a median of +18% for the annualised growth rate in the quarter.
In our view, risks are tilted solidly to the downside of this number, due to the narrow margin for error afforded by high hospital occupancy rates and the resulting risk of further extensions and expansions in restrictions.
Even if the rate of daily case growth is falling, it may not fall fast enough for states to avoid expanding restrictions due to health system constraints.
63 Forecasts for US Private Consumption (QoQ %) Submitted to Bloomberg
MEDIUM-TERM RECOVERY MARKED BY HIGH UNCERTAINTY DUE TO “SCARRING” AND OTHER FACTORS
Beyond the immediate future, the rate at which the US economy will recover the output lost in Q2 will depend on the net outcome of several offsetting forces. At the moment, a majority of global institutional forecasters including most central banks envisage that most major economies, including the US, will regain pre-COVID levels of GDP growth at some stage in 2021 or early 2022. The IMF’s June World Economic Outlook, for example, projected an 8% decline in US GDP in 2020, followed by 4.8% growth in 2021. The latest Fed member projections were more optimistic at -6.5% and 5% respectively for 2020 and 2021.
- Aside from the duration of COVID restrictions, the key assumption for medium-term forecasts of any economy in the current environment is the effect lasting drag on consumer spending and business investment, known as hysteresis in economics parlance or “scarring”. For consumers, the single biggest contributor to long term changes in behaviour is the threat of joblessness. The depth and persistence of job losses is, therefore, a sign of how lagged the US recovery will be. In past recessions, the proportion of workers laid off temporarily versus permanently was a key predictor of how long output would take to regain its pre-recession peak.
- Further fiscal stimulus represents a tailwind, but one that is mostly baked-in to existing forecasts. With over $3 trillion in stimulus already enacted, fiscal policy has been significantly quicker and more substantial than in previous recessions. In the short run, delays over the next major round of stimulus spending seem to suggest appetite is diminishing for further spending. On balance, we believe some compromise between the legislation currently being proposed by Senate GOP leaders and House Democrats will be made before the November election.
- The details of recent employment reports and the pattern of unemployment suggest a high risk of lasting damage to the labour market and consumer behaviour. Of the 4.8 million workers re-hired in June, almost 3 million were in leisure, hospitality and retail. It is precisely these sectors that will be most affected by the additional lockdowns in June, raising the risk of employers being either forced into insolvency or extremely cautious to re-hire workers a second time. Leakage from temporary to permanent unemployment in the June jobs report also illustrates the risk of lasting damage from the second wave of lockdowns: the rate of permanent job losers rose by more than 500,000 in the month. This suggests that although many workers were re-hired, lasting damage in the form of permanent job losses continued in the background.
- The US election represents another source of uncertainty. There is a possibility that Donald Trump will refuse to concede electoral defeat despite a negative result in the election. This is a difficult risk to price given the US has not had a contested electoral result in more than a century, but the risk of a serious constitutional crisis is unlikely to be taken well by markets. The effect of an ultimate Biden win on this on the dollar is ambiguous; on one hand, an improved global growth outlook and easing China tensions could see the dollar weaken as haven demand ebbs. On the other, a Biden win could spur positive sentiment in the currency and optimism for better management of the coronavirus pandemic.
FOMC READIES CURVE-FLATTENING RESPONSE TO STALLED RECOVERY
We believe FOMC policy over the medium term will likely be characterised by an aggressive response to additional growth slowdowns, and a more dovish reaction function that places greater emphasis on restoring a tight labour market, and less emphasis on fears of an inflationary overshoot. Speaking in a press conference following the FOMC’s latest policy announcement, Jerome Powell warned the economic recovery would have a “long tail where people are struggling to get back to work”. However, unlike the long tail following the 2008/2009 global financial crisis, statements from Powell and other policymakers suggest that the Fed will be more concerned about shortening this tail and hastening the path back to full employment, and less concerned about inflationary overshoot.
Several aspects of recent FOMC communications make it clear that the Fed is readying additional easing measures in response to a stall in the economic recovery during Q3.
We monitor quite a lot of what we think of as sort of non-standard high-frequency data. That’s become a very important thing, even more important than usual in the work that we do and what that data shows on balance is that the pace of the recovery looks like it has slowed since the cases began, that spike in June…on balance, it looks like the data are pointing to a slowing in the pace of the recovery, but I want to stress, it’s too early to say both how large that is and how sustained it will be. We just don’t know yet because we have to wait to see the actual data on spending and employment come in.
-Jerome Powell FOMC press conference 29/07/2020.
Combined with the other recent FOMC communications including minutes and the official statement, it seems highly likely the Fed will take additional easing action as early as September when official data are likely to confirm the bearish message coming from alternative data. The three key tools will be extensions to the Fed’s myriad of lending and credit easing programs, asset purchases, and enhanced forward guidance. With most of the Fed’s section 13(3) credit and asset purchase facilities experiencing uptake well below their current limits, expansion of the facilities or loosing of criteria may be an insufficient measure in isolation. Simply increasing the pace of asset purchases is an option, and is likely to be taken given the incoming wave of treasury issuance necessary for financing fiscal stimulus. Purchases are already not limited by any cap, although a minimum monthly purchase could be announced. Enhanced forward guidance would be a means of improving the transmission of asset purchases, by anchoring medium and longer-duration yields at low levels. Finally, direct yield curve control could be implemented. In our view, September is highly likely to see the implementation of enhanced forward guidance, with a combination of other measures drawn from the above options that will have the net effect of creating a lower, flatter US yield curve.
FOMC policy likely to further flatten US Treasuries curve
In addition to further easing in Q3 and Q4 2020, there are good reasons for expecting a more dovish reaction function from the FOMC in 2021 and beyond. Firstly, under Jerome Powell’s leadership, the FOMC was placing additional emphasis on symmetry in its inflation target as early as 2018. The Fed’s ongoing strategy review, which has now been resumed after a COVID-related hiatus, is likely to feature further formalisation of the shift towards symmetrical targeting and reduced emphasis on upside inflation risk that has already de-facto occurred. The adoption of an explicit time-average inflation target is a distinct possibility. With inflation having run below target for the past decade, adopting average inflation targeting would be a clear signal that the FOMC intends to prioritise labour market recovery over upside inflation risk. Secondly, messaging from both Chair Powell and other FOMC has increasingly emphasised the desirability of a tight labour market as opposed to the risk of an inflation overshoot, partly due to the benefits of seen for Black and Hispanic workers towards the end of the Obama-Trump labour market expansion. With distributional goals increasingly a matter of discussion for monetary policy, we believe the Fed will err on the side of running the labour market hot as opposed to inflation control.
Real US yields turn deeply negative
Author: Ranko Berich, Head of Market Analysis