In our 2020 Outlook published at the end of last year, we discussed why we expected the US dollar to weaken over the course of 2020.
We highlighted improved global growth reducing haven demand, as well as the Federal Reserve’s so-called reaction function becoming less sensitive to upside inflation risk, in turn creating a “soft landing” for the greenback.
This call, made back in late Q4, held up fairly well until emergence of the coronavirus outbreak, which has lowered global growth expectations, increased demand for safety, and resulted in the re-emergence of broad dollar strength.
The price trends seen in the US dollar over the past 12 months have been consistent with a paradigm where the US dollar outperforms during periods of global growth concerns, and weakens on rising growth expectations.
In the past, these two dynamics were accompanied by a third – USD strength during periods of US economic outperformance. The three dynamics together completed a “Dollar smile”, a popular metaphor often cited by the sell-side, generally to explain broad dollar trends.
Our bearish view on the dollar is informed by an expectation that the third dynamic – dollar strength driven by strong US performance – will weaken due to a more dovish Fed reaction function. This means that despite a relatively robust economy, we believe risks remain tilted to the downside for the dollar through to the end of this year.
In order to make point currency forecasts, base case assumptions are necessary. The most significant assumption we make is that the coronavirus outbreak will be contained at some point in H1 2020, allowing global growth to recover. The global effects of the outbreak will be significant, but contained to Q1 and the start of Q2.
Conditional on this base case, we believe a more dovish FOMC reaction function will lead to a weaker US dollar towards the end of the year, despite the US economy remaining in good health and even outperforming many peers. Aside from this base case, the upcoming US presidential election presents a source of “wild card” uncertainty, given the possibility of radical changes in both domestic and foreign policy in the US.
The US economy remains robust by most measures, having weathered last year’s trade war shocks to register 2.1% annualised growth across both Q3 and Q4 2019.
Consumer spending rose 1.8% in Q4, providing more than enough expenditure growth to offset a nasty 6.1% fall in private investment. Business surveys from January seem to indicate that easing trade tensions improved sentiment, especially in the manufacturing sector.
The labour market also struck a particularly firm note in the New Year, with nonfarm payrolls rising 225,000 in January. Importantly, wage growth continues to show no signs of accelerating significantly, despite the current economic expansion entering its 11th year, and the unemployment rate remaining at its lowest level since the 1960s.
Steady wage growth will support the US economy, but a lack of acceleration in year on year wage growth will likely prevent the Fed from worrying about upside inflation risk.
Looking ahead, although global growth is likely to be subject to a severe negative shock in Q1, the US economy is far better suited than most to maintain its momentum.
Low reliance on external demand combined with a robust labour market and confident consumers mean that although the risks to growth are limited to the downside, a significant derailing of the economy is not likely.
Chart: Bloomberg Dollar Index
USD weakened in a broad sense over Q4 2019, as it became clear a “phase one” trade deal would be struck. Just as 2020 seemed set to enjoy a broad risk rally and an extension of dollar weakness, the coronavirus outbreak bought fresh concerns about global growth. The dollar has since duly rallied.
The Fed’s reaction function is becoming significantly more dovish
Faced with these favourable conditions, the Federal Reserve was already reticent to give any indication of hawkishness even before the coronavirus outbreak, having spent 2019 undoing most of 2018’s rate hike cycle.
The 2019 cuts were accompanied by increasingly explicit acknowledgements that the FOMC was becoming far less concerned about upside inflation risk.
In delivering the final rate cut, in October, Jerome Powell said the FOMC “would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concern.”This marked a radical departure from the prevailing view under Janet Yellen, when gradual rate hikes were viewed as necessary to mitigate the risk of needed to raise rates quickly in the future.
General comments from FOMC members in January has confirmed that the bar for a move in rates is set high in the short-run, with several members making comments about current interest rates being appropriate. The Fed’s strategy review, which is likely to be completed around the middle of the year, is highly likely to emphasise a symmetric policy target.
For markets, this will be a clear signal that the FOMC will be less worried about the risk of an inflation overshoot, particularly a small or brief one.
When viewed in the context of only moderate inflationary pressure from wages, these comments and developments suggest that the FOMC’s reaction function is likely to be considerably more dovish in 2020.
Chart: Market-implied expectations of future Federal Funds Rate vs actual Federal Funds rate
Fixed income markets were expecting rate cuts in 2019 months before the FOMC delivered, and are once again pricing in further easing.
How long will haven demand from coronavirus support USD?
Our view of the dollar’s underlying dynamics suggest that the risks remain weighted to the downside for the dollar, conditional on improved global growth. The coronavirus outbreak represents a very substantial disruption to this condition.
Estimates of the drag the virus will create on global growth depend on two things – the duration and spread of the outbreak, and the cost to growth due to containment measures.
These estimates are subject to very high uncertainty, especially around the duration and spread of the outbreak. Despite this uncertainty, global central banks and private forecasters are currently operating with a fairly widespread assumption that the outbreak will be contained at some point in Q1 or Q2.
Despite this uncertainty, global central banks and private forecasters are currently operating with a fairly widespread assumption that the outbreak will be contained at some point in Q1 or Q2.
For example, the Reserve Bank of New Zealand (RBNZ) recently surprised markets by leaving monetary policy firmly on hold, describing the impact of coronavirus on global growth as having a “short duration”. Independent forecasters such as Goldman Sachs and Pantheon Macroeconomics have a range of estimates of the Q1 impact to growth both in China and globally, but generally expect the outbreak to be contained and for growth to recover by Q2.
On the whole, our forecasts are conditioned on this base case: growth will suffer a severe but unknown shock in Q1, keeping the dollar bid as a relatively well insulated haven.
At this stage, the US presidential election is too far away and with no clear Democratic nominee, it is difficult to infer any possible implications for the dollar. However, with presidential candidate Bernie Sanders currently leading the Democratic primaries and the prospect of a newly-re-elected Trump re-starting trade wars, the election presents a source of “wild card” uncertainty for both the dollar and global markets.
An additional downside risk to the dollar comes from the possibility of rate cuts from the Federal Reserve in Q1 or Q2 in response to a severe deterioration in the global growth outlook and the US outlook in particular.
This possibility is not in our base case, which envisages containment of the virus by China and major economies by some point in Q2, and is not yet apparent in hard or soft US economic data. But we do note the US yield curve has once again inverted over the 3 month – 10 year horizon, and so some tail risk of an early rate cut from the Fed is worth acknowledging.
An additional near-term downside risk to the dollar comes from the prospect of rate cuts from the Federal Reserve in Q1 or Q2, in response to a severe deterioration in the global and US growth outlook.
Although general comments from FOMC members in January have suggested that the bar for a move in rates is set high in the short-run, markets have already begun to price in easing. This has taken some of the edge off the dollar strength seen in recent weeks.
Chart: US yield curve inverts again
Yield curve inversion occurs when short dated yields are greater than long dated yields from the same country. Historically it has preceded several significant US recessions, and may have been a factor for the FOMC in deciding to ease rates in 2019.
The FOMC’s March meeting will be an important litmus test for how willing policymakers are to engage in further “insurance” rate cuts. With the US yield curve already inverted, unless the global outbreak eases rapidly a rate cut in March is becoming increasingly likely.
We assign a moderate 60% probability to a rate cut from the FOMC in Q1 or Q2, a development that will limit further dollar strength.
Author: Ranko Berich, Head of Market Analysis at Monex Europe.