The American currency is currently under pressure from all sides, threatening to end its long-running bull cycle. Has COVID-19 pushed the greenback to a turning point that could usher in a period of protracted weakness?
Financial safe havens such as gold, the yen, and the US dollar are peculiar things. Much sought-after during times of turmoil in financial markets or economic crises, they tend to rise strongly as investors attempt to hedge their portfolios against substantial losses.
Little wonder that gold was hitting record highs this summer, and is expected to continue rising after languishing in the doldrums for much of the past decade since the 2008/2009 financial crisis.
The US dollar had already seen nine years of strength even before the coronavirus began spreading around the globe in March. That's why many analysts were caught by surprise when the greenback rallied to a new high for the year in mid-March despite fundamental data suggesting the currency was hugely overvalued.
Since then, however, the US dollar has been on a steady downward trajectory against a basket of currencies comprising the United States' main trading partners and is now close to 10% below its peak in March.
As the greenback hit a two-year low on Tuesday following its worst month in a decade, bearish investors are already sounding the death knell for the dollar's bull run, and have begun shortening it, meaning they are betting on the currency falling further.
Data from the Bank of International Settlement indeed seem to suggest the US dollar is the most overvalued major currency based on trade-weighted figures, which take into account countries' relative trade balances. It shows that the currency is valued around 16% stronger than it should be, compared with the euro, for example, and based on purchasing power parity data.
Jack McIntyre from Brandywine Global Investment Management thinks the dollar has been "overvalued for a long time," which might finally be a "catalyst for a multi-year downtrend."
He also said that a "policy or economic shock" could quickly change an overvalued currency's trajectory, and "that's what seems to be happening" with the US dollar as the coronavirus pandemic keeps the US economy in a tight grip.
By far the biggest blow to the US dollar has come from the global pandemic that's prompted unprecedented policy responses from both the US government and the country’s central bank, the Federal Reserve.
Unemployment in the US has been rising much faster than in Europe during the pandemic and government wage subsidies are set to expire earlier
The Trump administration has pumped more than $3 trillion into the US economy as part of efforts to alleviate soaring unemployment and to support businesses suffering from nationwide lockdown measures. The record stimulus is already stoking inflation jitters among investors and weighing on the dollar.
Moreover, Fed Chairman Jerome Powell suggested last week that the US central bank was comfortable with higher inflation, after pledging earlier this year unlimited liquidity to support the battered US economy.
The grim outlook for US growth, which shrank by an annualized rate of 31.7% in the second quarter, and the Fed's near-zero rate policy have pushed down government bond yields closer toward the rest of the world, making US dollar-denominated debt less attractive for investors from abroad. Inflation-adjusted real yields in the US are now negative, similarly to those in Europe.
Some analysts also see the current stalemate in the US Congress over further government stimulus as weighing on the dollar. And finally, the upcoming US presidential election, including uncertainty over the government's further response to the pandemic, are proving formidable headwinds for any dollar rebound.
Meanwhile, the dollar's decline has been fueling talk of the world's second-largest reserve currency, the euro, rivaling the greenback's supremacy. And indeed, Europe’s common currency has rallied about 12% since March, supported by the EU’s €750-billion joint stimulus package and the region's ability to control the spread of the virus better than the US.
In addition, the economic recovery in the bloc also seems to be on a stronger footing than in the US, which made the month of August the most bullish for the euro in the options market. Speculative investors are now betting on a jump to $1.25 for the euro, which briefly traded above $1.20 for the first time in more than two years on Tuesday.
"We expect the euro area economy to outperform other countries and see the euro as underowned in international portfolios and undervalued in our fair value models," Jari Stehn, chief economist at Goldman Sachs, wrote in a note to investors.
However, the euro's good fortunes could take a hit if the single currency were to climb to a threshold that would inflict pain to the eurozone recovery.
Sectors which have a strong cost base in the euro area but get paid in dollars are likely to be worst affected. A stronger currency makes exports less competitive and depresses price growth by making imports cheaper. This holds especially true for Germany's export-oriented industries such as the auto sector, aerospace and electrical engineering.
Analysts vary in their opinions about when a rising euro becomes painful for eurozone business. Ankit Gheedia, macro equity strategists at BNP Paribas sees the threshold at around $1.40 for the euro and thinks another euro rise by 10% will hit profit margins "in a big way." Others like Esty Dwek from Natixis Investment Managers see the pain level "probably closer to $1.25."
Little wonder that the euro rally is already drawing the attention of the European Central Bank (ECB) which has helped keep the euro lower in the past via huge asset purchases and negative interest rates.
ECB Chief Economist Philip Lane underscored in an online conference Tuesday evening that the euro-dollar exchange rate "does matter."
"If there are forces moving the euro-dollar rate around, that feeds into our global and European forecasts and that in turn does feed into our monetary policy setting," he said.
The ECB will hold its next policy meeting on September 10, but there's precious little the central bank can do other than try to talk down the currency by highlighting the persistent economic uncertainty in the eurozone and leaving the door open to more asset purchases later this year.