Dollar Tantrums

The Uncertainty Is About US Long-Term Growth, Not Inflation

Kurt Winkelmann, Raghu Suryanarayanan, Ferenc Szalai

Since March, the US dollar lost about 8% of its value relative to major currencies. Some analysts pointed that this loss reflected markets' pricing of higher inflation in the US. While investors should worry about inflation risk, such concerns have not materialized yet, nor been priced into markets - as dollar denominated debt assets still maintain their privileged position as dominant reserve assets of the world. Instead, investors would be better served focusing on long-term prospects for US economic growth. According to our models, the decline in the dollar is consistent with markets' pricing of lower long-term real economic growth with higher uncertainty - and not higher inflation - relative to developed economies. Further relative deterioration in trend growth could well lead to investors losing trust in the stability of US fiscal balances and the demise of the US dollar, leading to higher inflation and potentially more volatile global financial markets.

Exhibit 1 - Trade Weighted US Dollar Index

Trade Weighted US Dollar Index

As shown in Exhibit 1, the trade weighted US dollar index suffered a significant and sustained 8% loss since March 23rd, 2020. This fall follows unprecedented highs reached by the dollar at the start of the pandemic as investors were seeking refuge in the world's dominant safe haven currency. Compared to historical standards, though, this fall was not dramatic, and the dollar is, at this stage, far from being undervalued relative to other major currencies. However, investors are right to pay attention. According to our models, the declining trend in the trade weighted US dollar index reflects investors' pricing of relatively lower US long-term real economic growth and higher growth uncertainty compared to other benchmark countries in the index currency basket - including Eurozone, Canada, UK, and Japan - and/or higher US long-term inflation compared to these countries. The key questions then for investors are whether the recent decline in the US dollar index reflects markets' concerns about US growth, inflation, or a combination of both lower growth and higher inflation (relative to the rest of the world)? And what would further degradations in growth prospects mean for the US dollar and credibility of US fiscal balances?

Our models point to currency markets' pricing of fears of a prolonged period of relatively lower trend growth and higher growth uncertainty - and not of higher inflation. Indeed, as portrayed by Exhibit 2 and according to our models, long-term prospects for inflation for the US have remained stable over the last 8 months relative to major countries in the index currency basket, even despite the dramatic recent increase in US government borrowing. As discussed in our previous note, the main reason is that markets still have confidence in US fiscal and monetary policies. In turn, debt assets issued by the US government continue to be seen as the world's safest assets. This trust is further supported by the privileged status of the US dollar as the world's dominant reserve currency. The US dollar retains its preeminent position in part because the US remains the primary engine of global growth, as shown in Exhibit 2, and also thanks to the perceived credibility of US fiscal and monetary policies.

Exhibit 2 - US Long-Term Growth, Growth Uncertainty, and Inflation Relative to Major Developed Economies

US Long-Term Growth, Growth Uncertainty, and Inflation Relative to Major Developed Economies

Moreover, Exhibit 2 suggests investors should be concerned about the recent relative changes to US long-term real economic growth, not just differences in absolute levels. Our models are consistent with markets pricing in relatively lower long-term trend growth with higher uncertainty about the trend in the US, compared to other major economies and the start of the year. These changes in trends were driven by lockdown measures, the resurgence of infections and the devastating impact of both on the labor force and output productivity. More precisely, our forecast for US long-term real economic growth fell from about 1.5% to 1% - a significant 50bps drop ! At the same time, our long-term growth and uncertainty projections, while bleak, remained broadly unchanged for the other major countries in the currency basket.

Exhibit 3 - US Long-Term Inflation Under Alternative Scenarios

US Long-Term Inflation Under Alternative Scenarios

While there is no cause yet for dramatic concern, as prospects for long-term growth in the US still fare better compared to other developed economies, providing support for the US dollar and dollar denominated debt. Nevertheless, the real worry for investors is the risk of prolonged relative deteriorations in US long-term growth. These fears could well become more likely to materialize in the context of possible untamed resurgence(s) in Covid-19 infections in the US and worldwide and unprecedented (and unmanaged) levels of US government debt. In such a doomsday scenario, investors could be quick to distrust US fiscal balances and revisit the privileged position of the US dollar denominated debt assets. A run on the dollar and US government debt, according to our models and as depicted in Exhibit 3, would lead to spiraling inflation rates similar to the 1970s experience or perhaps even worse , along with global financial instability.

Going forward, investors are well advised to monitor changes to the main drivers of long-term growth - growth in the labor force and total factor productivity - in the US and globally, and their impact on US fiscal balances, the privileged status of the US dollar, portfolio returns and strategies.

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