Since the start of the year the U.S. dollar has appreciated by roughly 1%, continuing a near-decade long trend that was only briefly interrupted in 2017. The dollar’s climb higher seems inexorable, and with its negative implications for U.S. multi-national earnings and U.S. investor returns in international markets, many investors are wondering: what is the outlook for the U.S. dollar?
At a macro level, the dollar is influenced by two broad forces: balance of payment flows and financial flows. The first force suggests the U.S.’s current account balance will partially influence the dollar, with a surplus being dollar-positive and a deficit being dollar-negative; the second suggests the relative attractiveness of U.S. asset expected returns will either encourage or discourage foreign investment, thereby increasing or decreasing the demand for the dollar.
Presently, the U.S. maintains a very large current account deficit, and has done so with few interruptions since the late 1970s. The increased presence of globalization, coupled with enormous U.S. demand for foreign products – like European luxury goods or inexpensive “staples” made in emerging Asia – will likely continue this trend. This large deficit floods the global marketplace with U.S. dollars, putting downward pressure on the currency as supply balloons.
In addition, the relative attractiveness of U.S. financial assets is starting to wane. Interest rate differentials are narrowing as a result of COVID-19, with the Federal Reserve (Fed) intent on keeping the Federal funds rate at its lower bound for at least two more years; and the cyclical composition of many international economies and equity markets should mean that relative economic growth and equity market performance will be stronger overseas during the global recovery. This combination should pull foreign capital out of U.S. assets, putting additional downward pressure on the dollar.
Still, investors should remember that these are large-scale structural forces that typically take years to fully manifest. We continue to believe that over the next 10 to 15 years, the dollar will weaken; but the exact catalyst for this trajectory change is elusive.
In the short-term, it appears that a third force – sentiment – is mightier than other longer-term drivers. Periods of relative global calm, like in 2017, allow for greater risk tolerance, pushing money into riskier assets like those overseas; but in periods of high global stress, risk aversion takes primacy, pushing assets into relative “safe havens” like U.S. Treasuries. This year’s bout of dollar strength, particularly in the first quarter, was a reflection of deteriorating sentiment thanks to the rapid and uncertain spread of COVID-19.
As a result, investors looking for a USD regime change should look for improvement in the headlines. Unfortunately, with trade tensions between the U.S. and China re-escalating, signs of increased strain in the Korean peninsula and, of course, the fundamental COVID-related uncertainty in a pre-vaccine world, this does not seem likely in the near-term.
The U.S. dollar has strengthened for almost a decade
U.S. Dollar Index (DXY), index level, monthly
Source: FactSet, ICE, J.P. Morgan Asset Management. Data are as of June 25, 2020.