US DOLLAR: WAKENING FURTHER

We see no near-term catalyst for further US dollar weakness and believe that verbal intervention by the European Central Bank (ECB) should mitigate any further euro appreciation for some time. Our new year-end target for the US dollar against the euro – at 1.20 – is similar to current exchange rate levels. Yet we expect the US dollar to depreciate further in 2021 and 2022. As the EU recovery fund brings an extra layer of fiscal integration, the US dollar may end 2021 at 1.25 versus the euro, which would be at the low end of the range of fair value estimates. We believe the US dollar could fall to 1.28 against the euro in 2022.

Forward contracts point to a flat path for the euro/dollar exchange rate over the next year or so. Yet our analysis suggests the US dollar is overvalued by around 8% versus the euro, and we use this information to determine the direction of our long-term forecasts. 

The U-shaped economic recovery we continue to expect suggests that demand for US dollars could subside further. In part, this has to do with oil demand, which looks set to improve gradually. As oil supply is declining, prices could rise, which would increase the supply of ‘petro-dollars’ to oil-exporting countries. This trend could reverse the demand for US dollars that occurred following the steep drop in oil prices in early 2020.

We expect the Federal Reserve’s balance-sheet expansion to be greater than that of other central banks, which will increase the supply of US dollars. The Fed has also cut rates more aggressively, and 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. The trade deficit means the US is spending more overseas than it is taking in, which means it needs to borrow money to make up for the shortfall.

So we have a rising supply of a still overvalued US dollar meeting and eventually exceeding demand, which should weaken the currency. While this has been going on for some time, what’s changed lately is that we now think that real rates should decline further in the US relative to the euro area, and that the EU recovery fund has the potential to boost the euro. Let’s consider both drivers.  

A REAL GAME

We believe real interest differentials are set to shift more against the US, further weighing on the dollar. The inflation compensation implied by US inflation-linked bond yields has already started to pick up. However, it remains below both the Fed’s 2% target and the average since the late 1990s and following the 2008 global financial crisis. Furthermore, the Fed’s shift towards average inflation targeting, announced by Chair Powell at Jackson Hole recently, means the central bank will likely cap nominal yields even when there’s no economic slack anymore. The Fed hopes its policy will encourage investors to push US inflation compensation higher. 

While we don’t believe inflation compensation in the US has scope to rise rapidly in the near term, it’s likely to rise even less in the euro area. This is because the European Central Bank appears more constrained when it comes to engineering further stimulus. After all, policy rates are already negative and further cuts may damage the financial sector. Balance-sheet expansion may face political hurdles, and bond yields were already very low even before the pandemic hit – which is why they haven’t fallen that much this year.

The ECB is also likely to announce a similar change to its reaction function. Rather than keeping inflation below but close to the target of 2% over the medium term, the central bank will probably shift towards a symmetric target, so that markets no longer see 2% as a potential ceiling. Even though this may make a difference over time, our view is that it make may make less difference relative to the Fed’s change – at least for the moment. This is because actual inflation and market-based inflation expectations in the euro area have been very low for a while now, suggesting investors believe that low inflation will persist despite the ECB’s best efforts to revive growth.

The euro has been inching higher against the dollar lately, and not just because the US currency appears to be going through a structural weakening trend. It’s also because the euro is strengthening. This has to do with fiscal integration and fiscal support more generally. After EU leaders agreed in principle to the EUR 750 billion recovery fund at their July summit, the process of ratification by the European Parliament and all 27 national parliaments is likely to start soon. We expect this process to last for the rest of the year. Once this is all up and running, the recovery fund will finance initiatives to encourage digitalisation and fight climate change, as directed by the European Green Deal announced late last year. 

GOLD: STAYING WELL SUPPORTED

After gold prices recently met our target, we have raised it to USD 2,100 by the end of 2020, USD 2,250 at the end of 2021 and then USD 2,400 by the end of 2022. Gold futures show a more or less sideways trajectory over the next 12 months or so. The main thing that’s changed is that real yields have fallen further: the lower the real yields of US government bonds, the lower the opportunity cost of holding competing assets such as gold. As economic uncertainty fades, demand for safe-haven assets including gold should fall. But this is only likely to take a little shine off gold prices, as ultra-low real yields are a key support. 

From a supply perspective, gold mine production appears to have a rather limited correlation with gold prices. It peaked in 2018 following a multi-year expansion despite falling prices from 2012 to 2015. Even though the price of gold has risen sharply this year, gold mine production is forecast to fall by approximately 3% globally. While there’s some uncertainty around these estimates, it is then projected to continue to contract gradually over the next decade or so. 

Demand for gold has remained relatively inelastic to price movements over the past several quarters. This is due to the precious metal not having a substitute for the majority of its uses. Even though current demand is significantly above or below its long-term average for some categories – ETFs and jewellery, respectively – the latest figures suggest all other categories remain within 1% of their long-term averages.

GOLD ETFS A KEY DRIVER

Gold ETF investments have hit highs not seen since 2011, with nearly USD 40 billion flowing into funds during the first half of the year. Apart from the benefits of gold as a portfolio diversifier, this purchasing behaviour can be attributed to the Covid-19 pandemic, which caused widespread panic and distress in markets. Investors flocked to the safety of gold ETFs in record numbers, pushing up prices and offsetting the decline in jewellery demand in major markets. 

The proportion of total demand that ETFs and similar vehicles represent has increased notably in recent years, rising from about 8% in early 2016 to 28% currently. Overall investment demand has averaged 30% of total demand over the same period. It now represents approximately 50% and has taken share away from jewellery (which usually accounts for 50%). This could be explained by jewellers not seeking to purchase gold while the price is high – and waiting for a decline – coupled with the significant contraction in economic activity in China and India.

Gold prices tend to be very volatile, with a six-month standard deviation of USD 120. This means that the difference between current levels and our year-end target of USD 2,100 are within the typical volatility bands.  

Sources: Quintet, KHN.org, multiple underlying news sources

COVID-19 WATCH

Globally confirmed cases of Covid-19 have now exceeded 27 million, up from approximately 25 million seven days previously.   We recognise the huge human cost of the virus, which continues to have social and economic consequences for so many individuals, families and communities.   In the chart below we compare the most severe measure of human cost – deaths attributed to Covid-19 – to GDP, which is the most general measure of economic cost. The methods for compiling these figures vary between countries, which makes international comparisons difficult. We’ve only included countries with a complete dataset and more than 10 deaths per 1 million inhabitants.

The composition of each national economy – such as its exposure to international trade – will affect its economic performance during the pandemic. However, those countries that have been affected the most by Covid-19 have generally suffered the deepest economic contractions.

Notable exceptions include the US, which has been relatively resilient compared with its neighbours, such as Mexico, and other large economies, such as the UK and France. Sweden’s relatively relaxed approach to social distancing has attracted a lot of attention, and its economy has performed relatively well considering the proportion of Covid-19-related deaths.