The Unexpected Downfall of the US Dollar
Understandably, fluctuations in the US dollar have wide-ranging consequences on the global economy due to its status as the primary reserve currency. Spillovers originating from changes in the American currency go beyond the traditional impacts of foreign exchange movements on international trade, hence why any dramatic changes to the dollar is likely to cause havoc in markets. [1]
In March, panic instilled by the coronavirus pandemic led to a sudden dollar rally as the US currency appreciated by 9% in a few days [2]. Investors and companies poured into the currency they valued above all others, in their efforts to navigate through an unprecedented economic turmoil. Indeed, in light of uncertainty, investors tend to turn towards the US dollar as a safe-haven asset – often as a hedge against global markets tumbling [3]. Markets witnessed a ‘fly to quality’ movement typical of worried investors, familiar from the 2008-09 global financial crisis and multiple geo-political confrontations in past decades.
Figure 1: USD Index Fluctuations (% Changes Month on Month)
However, a large sell-off in July propelled the dollar into its worst monthly performance since September 2010, sending the euro and pound sterling higher. The dollar index, a measure of the greenback against a basket of six major currencies, slumped by 4.4% throughout the month of July to reach its lowest level in two years, as seen above. [4]
Negative Sentiment Drives the Us Dollar Downwards
Needless to say, the dollar encountering such a dramatic downwards movement was unexpected at the beginning of the year. The world’s economic hegemon was enjoying consistent economic growth and record-low unemployment rates until the coronavirus pandemic emerged [5]. Higher interest rates in the US relative to Europe and Japan equally helped to create a friendly environment for the dollar.
Furthermore, a sharp decline in the dollar amid global economic uncertainty is unusual considering its safe-haven status. Investors tend to find safety in the American currency in times of turmoil and as well described by a Financial Times article, “when the going gets tough, the dollar jumps” [6]. Yet interestingly, the dollar has been following a downwards trend ever since its rally in March.
Strong negative sentiment vis-à-vis the currency is to blame for its downfall – and below is an analysis of the combination of factors which influenced a deteriorating dollar, notably the domestic mismanagement of Covid-19 and quantitative easing measures employed by the Federal Reserve.
The Federal Reserve Intervenes – At the Expense of a Weakened Greenback
The US has perhaps demonstrated one of the most inefficient handling of the Covid-19 epidemic within the developed world. Its mismanagement of the pandemic, originating mainly from political divide over how to surpress the virus, has resulted in slow and uncertain economic recovery. As the country with the most recorded cases and deaths worldwide, the government is now tasked with recovering from a dramatic fall in economic activity and output – of a scale similar to the Great Depression. Data provided by the US Bureau of Economic Analysis demonstrates a 32.9% annual drop in real GDP in the second quarter of 2020 [[7]](https://www.bea.gov/news/2020/gross-domestic-product-2nd-quarter-2020-advance-estimate-and-annual-update#:~:text=Real gross domestic product (GDP,the Bureau of Economic Analysis.&text=The "second" estimate for the,released on August 27%2C 2020.). The Bureau attributes this decrease to several factors, the most dominant ones being lower household expenditure, exports and private inventory investment. US consumer confidence data also weakened the dollar in the second quarter as households showed less belief in a prompt economic recovery [8]. Negative macroeconomic data has consistently pushed the dollar down in the past few months.
Federal Reserve chair Jerome Powell recently shared at a monetary policy meeting that the future of the US economy would “depend significantly on the course of the virus” [9]. Whilst other developed countries are slowly returning to higher levels of activity, the resurgence of cases in certain states has spread concerns amongst investors. Worried too much for their liking, they were reluctant to hold the currency – partly explaining the large sell-off in July.
The potential for a prompt economic recovery is still limited in the US – in contrast to Europe which has shown signs of unity, for once. The euro’s value appreciated by 10% since May as a result of the recovery fund program established by the European Union. The EU’s cooperative response to the pandemic created a significantly better economic recovery outlook when compared to the US. [10]
The economic toll derived from the pandemic called for stimulus measures to boost economic activity across the country. To counteract the detrimental effects of the pandemic, the Fed injected liquidity into the economy via quantitative easing measures.
In March, the Federal Reserve announced that it was willing to purchase up to $750bn in corporate bonds and $500bn in Treasuries as a way to maintain borrowing costs low for struggling businesses and individuals. The purchase of mortgage-backed securities and facilitation of credit for corporations, small to medium enterprises and state governments was equally included in their program. [11]
The Fed’s bond-buying program was effective in easing financial stress in markets at first, although pandemic outbreaks and a lack of economic recovery in the second quarter of the year has called for even more stimulus. By mid-June, the US central bank had purchased around $1.7tn of government debt and intends to buy $80bn of Treasury bonds per month in a full effort to keep short-term bond yields low. [12] Inevitably the dollar is taking hits from the excessive levels of money printing by the central bank. As the money supply of dollars significantly rises in the US, it has applied downwards pressure on the greenback.
Further stimulus signals lower yields for a longer period of time. By the end of July, the yield on US 10-year Treasuries was trading near all time lows, and reached just below 0.54%. Real yields, which take into account inflation, attained just below -1%, a record low. [13]
The US government bond market reflects the poor economic outlook which the Fed is attempting to combat. In the meantime, lower yields mean the dollar is losing in attractiveness – especially for yield-seeking investors who typically take refuge in Treasuries in times of economic downfall. Investors are looking for alternatives and are understandably moving away from the US dollar.
As a result of the debasement of the US dollar, investors are feeding into gold, which stood at an all-time high of $2060 a troy ounce early August.
US Politics Weighs on the Dollar
Election polls are favouring a Democrat win for the upcoming presidential elections in November. Joe Biden leads the polls by approximately 30 points ahead of Donald Trump, amid broad discontent over his approach to handling the pandemic and current civil unrest [14]. A strong poll performance for the Democrats has had a negative effect on the dollar, considering Joe Biden’s opposing stance on economic and regulatory policy.
In contrast, Trump’s presidential term was characterised by a strong dollar. His policy mix of aggressive fiscal spending and strong protectionist measures has kept the dollar trending at high levels. However this comes under threat if Joe Biden is to be elected, as his program is less supportive of the greenback. Joe Biden is currently advocating for more regulation for financial services and energy companies, less aggressive protectionist policy and higher taxes. [15]
In addition to the above, Donald Trump is undermining the idea of mass postal voting for the upcoming presidential elections in 3 months. There is still confusion as to the legitimacy of such voting system, as expressed by current president Trump – adding extra political pressure on the dollar. [16]
Conclusion
As US Treasury Secretary John Connally said during the Nixon-era to a group of European finance ministers, “the dollar is our currency, but it is your problem”. International investors are now trying to find their way around this American problem. The dynamics of the US dollar have altered in the past few months, and the question remains whether this trend will become the new normal.
Federal Reserve stimulus efforts to shore up the US economy have shown signs of success, notably in helping companies and households during this period of financial stress. A weakened dollar is essentially just a consequence of a much-needed accommodative monetary policy move by the Fed. Unfortunately, political issues surrounding the upcoming presidential elections and the management of Covid-19 has pushed the dollar unexpectedly low.