A Fistful of dollars

A Fistful of dollars



The old adage goes that if you ask 10 economists their views on something you get 11 different answers. But there is one topic on which nearly all economists seem to agree: there’s an apparent disconnect between the “despair” phase of sharp economic contraction, which may now be easing slightly, and financial markets already expecting a robust phase of economic “repair”. We propose a Counterpoint and believe that the apparent disconnect can be explained and should not unduly worry investors. Financial markets lead the economy and are influenced more by the coming change to growth than the current level of growth. So, for financial markets, the improvement in economic data, even if from a very weak starting point, is more important than the current depressed level of economic activity.


This has key implications for currencies. As the economy moves from “despair” to “repair”, the bid for safe-haven currencies is likely to lessen. We do not expect to see significant US dollar weakness overnight and against all currencies simultaneously. However, the U-shaped recovery that we envisage should eventually ease the risk-aversion component that has supported appetite for US dollars.

This would result in foreign exchange fundamentals playing a larger role once again. Demand for US dollars is likely to diminish as the global economy recovers and oil prices rise. The supply of dollars is likely to exceed demand, given that the Federal Reserve is doing more than the other major central banks in terms of balancesheet expansion, and has cut rates more aggressively, thus reducing the interest-rate differential.

This implies that the US dollar should go through a gradual topping process after a multi-year bull market – and then weaken. This should support the competitiveness of the US corporate sector and be positive for emerging markets – where we hold tactical overweight positions in both equities and hard-currency sovereign debt. And, as central banks around the world are attempting to devalue their currencies, another of our tactical overweights – gold – is likely to be a beneficiary.


Financial markets and the real economy are often discussed as if they were one and the same. But they are fundamentally different. Take the stock market. It is basically a discounting machine – an attempt to value companies’ future earnings. And that process has to do with spreadsheets and accounting models – as we discussed in our Counterpoint Weekly on 18 May – as much as behavioural impulses such as fear and greed.

Conversely, what is happening in the real economy is usually framed in the context of the current macro situation: Am I working right now? Do I feel confident about making my mortgage payment at the end of the month?

In short, markets are forward-looking and price developments before they show up in the economic data. They lead the economy, not the other way around. As an example, US data shows that the equity market typically begins to fall about four months before the recession starts, and then bottoms three to five months before the recession ends.


To give another example, European stock returns are often worse when the macro dataflow is good but starting to weaken, and they tend to be better when the dataflow is still weak but starting to improve.


This is important because April is likely to have marked the trough in economic activity. May saw some improvement in the data, as economies gradually reopened for business. However, making up for the lost output is likely to take a long time.


Investor appetite for the US dollar has been at fever pitch. And investors who have been bearish on the greenback were wrong time and again, sometimes for years, despite most ‘fair value’ models pointing to US dollar overvaluation.


US dollar bulls have been supported by a lack of alternative attractive financial assets outside the US. While appetite for the US dollar is still strong, and will not change rapidly, the bull case for the US dollar looks less compelling further down the line.

Consider the demand for US dollars. When we look at the outlook for the global economy, we expect a U-shaped trajectory. This will likely be a multi-speed process, as social distancing is lifted unevenly across countries and sectors. It will likely be faster where liquidity is the main challenge, as monetary and fiscal stimulus is ample. And slower where solvency is the problem.

The economic recovery suggests that the demand for US dollars could subside from current extreme levels. In part, this has to do with oil demand, which looks set to improve in the second half of this year. As oil supply is declining, this could potentially drive the oil price higher. A rise in the oil price would increase the supply of “petro-dollars” to oilexporting countries, reversing the demand for US dollars that occurred following the steep drop in oil prices in early 2020.


Consider the supply of US dollars. Our base case of a Ushaped recovery means that it will take time to reabsorb the huge economic slack. Inflation will begin to recover, but only with a lag, and from very low levels. This is likely to keep most central banks on an easing path throughout the forecast horizon. We expect the Fed’s balance-sheet expansion to be bigger than that of other central banks, thus increasing the supply of US dollars. Furthermore, the Fed has also cut rates more aggressively.


Similarly, changes in the US twin fiscal and trade deficits point to US dollar depreciation. The US will have to fund its large fiscal deficit by issuing a lot of debt. Meanwhile, the trade deficit means that the US is spending more overseas than it is taking in, thus needing to borrow money to make up for the shortfall.



The main risk to our call for a weaker US dollar is a further escalation of the trade tensions between the US and China. After all, the US seems dissatisfied that China is not delivering on the target purchases under phase 1 of the trade deal. And the Hong Kong situation adds an extra layer of uncertainty.

The key variable is whether the situation escalates. Because 2020 is a US election year, tough US rhetoric may find favour with voters. However, the economy is still very weak and polls suggest that voters care about their jobs above all else. This points to a “cold” trade war in the short term – with a lot of barking but limited biting.

Longer-term risks of a further and more meaningful escalation remain. We believe the issue is broader than trade. It encompasses technology, intellectual property and many other areas. However, to the extent that the trade war does remain a “cold” war, we would expect lower demand for US dollars to be exceeded by an ample supply. We do not expect this to happen very quickly. Rather, as risk appetite progressively returns, the US dollar should slowly peak and then start weakening.

This document has been prepared by Quintet Private Bank (Europe) S.A. The statements and views expressed in this document – based upon information from sources believed to be reliable – are those of Quintet Private Bank (Europe) S.A. as of May 28, 2020, and are subject to change. This document is of a general nature and does not constitute legal, accounting, tax or investment advice. All investors should keep in mind that past performance is no indication of future performance, and that the value of investments may go up or down. Changes in exchange rates may also cause the value of underlying investments to go up or down. Copyright © Quintet Private Bank (Europe) S.A. 2020. All rights reserved.

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