The broad, trade-weighted dollar will decline 6% over the next 12 months, Goldman says, in the bank’s 2021 global FX outlook.
Part of the thesis is predicated on the notion that the global economic recovery will be robust, an outcome that’s expected to sap demand for the dollar and USD assets, even if the US economy manages to sustain some semblance of momentum.
Anyone steeped in the discussion can write this script for themselves. That doesn’t mean it’s necessarily “right,” it just means the narrative is familiar.
The bank’s Zach Pandl notes that “for international investors, overweights in US markets have been almost unavoidable over the last decade.” Why? Well, simple. Corporate profits stateside have held up, buoyed in part by the tech giants, while Europe labored for years under the weight of the sovereign debt crisis and a slow, painful trek down the road to Japanification. Emerging markets, meanwhile, were challenged at various intervals by weakness in commodity prices and a Chinese economy that, while still robust, witnessed decelerating growth rates.
Then, beginning late in 2015, the US started hiking rates, albeit at a snail’s pace and with an almost immediate pause amid the deflationary spiral that unfolded in early 2016 following the previous summer’s yuan devaluation. The ensuing monetary policy divergence was exacerbated under Jerome Powell, when Donald Trump’s efforts to turbocharge the domestic economy prompted the Fed to adopt a more hawkish bent than they might have otherwise. That pushed up real yields, while Trump’s trade war and tax cuts increased demand for USD assets.
All of that easily outweighed the longer-term structural bear thesis which is almost always predicated on twin deficit concerns.
Now, though, the situation has changed. Or at least that’s the going assumption headed into the new year.
“This long stretch of US outperformance has resulted in high Dollar valuations and structurally long positioning in domestic assets,” Goldman’s Pandl wrote. “But the macroeconomic outlook has turned less favorable for the Dollar: the Fed has cut rates down to zero, removing the greenback’s carry advantage, and robust global GDP growth tends to lift the currencies of commodity exporters, emerging markets, and the economies most geared to global trade,” he added.
Of course, the dollar fell rather precipitously over the summer as the Fed moved to push real rates deeply negative following March’s dramatics. That helped bolster risk assets across the board.
There’s a mechanical element to this going forward that should probably factor into anyone’s outlook for the greenback.
“Real rates in the US have fallen substantially, and will probably decline further at the front-end of the yield curve,” Pandl went on to say, in the course of noting that this is “one way to interpret the Fed’s Average Inflation Targeting framework.”
If the Fed doesn’t hike until inflation hits 2% (and sustainably, at that), then the real funds rate will be negative 2% when (or maybe “if” is better) liftoff finally arrives.
Finally, Pandl runs through the rationale for a weaker dollar in the face of stronger global growth and buoyant risk sentiment, reminding clients that the causation runs both ways.
“When the global economy improves, investor demand for US Treasurys tends to fall, and if (unhedged) investors allocate into assets denominated in other currencies the value of the Dollar may also decline,” he said, adding that “economists also think the causation can run in the other direction, with a weaker Dollar supporting the global economy…. because [for example] Dollar depreciation improves the balance sheets of overseas borrowers with USD-denominated debt.”
All of this is familiar territory and those of a bearish persuasion on the greenback will also argue that the ballooning US deficit and America’s national “debt” burden “should” erode faith the greenback. As ever, I caution against using that terminology — it’s misleading. The biggest threat to dollar hegemony is unpredictable foreign policy and the incessant tendency to weaponize the US financial system in the service of “punishing” other countries, sometimes for not very good reasons.
The same caveats apply: If something goes “wrong” in earnest, all anyone will want is the dollar. The world re-learned that lesson in March, when everything that wasn’t tied down was summarily dumped to raise USD cash and meet margin calls. Additionally, any growth shock that pushes breakevens markedly lower could push up real yields, something the Fed will need to guard against.
In any event, Goldman’s expectation is that “the broad Dollar depreciation that began in mid-May of this year will extend into 2021–and possibly well beyond that.”