The dollar will depreciate by another 10-15% over the next 3 to 5 years as the election of Joe Biden as the 46th president of the United States has drastically reduced the risk of a trade war, according to currency strategist Aaron Hurd of State Street Global Advisors.
In an interview with Investment Officer, Hurd emphasises that roughly half of the rise in the dollar in the second half of Trump’s presidency was due to the trade war unleashed by the outgoing president. ‘That introduced a risk premium into the foreign exchange market which made the dollar relatively attractive as a safe-haven. Moreover, small, open economies are relatively more vulnerable to a trade war than a large economy like the US, which is less dependent on trade. That, too, had a positive effect on the dollar.’
The latter aspect also explains why the Chinese yuan has fallen far less in value in recent years than smaller emerging economies, says Hurd. This is despite the fact that Trump’s tariff measures were mainly aimed at China.
The second reason for the dollar appreciation during Trump’s presidency was his government’s pro-cyclical fiscal policy. ‘Trump’s tax cuts provided an additional stimulus to the economy at a time when unemployment was already very low. The Fed had to respond by raising interest rates more quickly to prevent overheating. That in turn led to a stronger dollar,’ explains Hurd.
This second reason for the dollar strength had already disappeared with the outbreak of the coronavirus pandemic and the Fed’s subsequent interest rate cuts. This explains the -8.5% fall in the dollar exchange rate against the euro since February.
But Biden’s election puts additional pressure on the dollar, according to currency analyst Ima Sammani of Monex Europe. ‘Even before the election, you saw that every time Biden was deemed more likely to win, the dollar fell and currencies like the Mexican peso and the yuan gained in value.’ Indeed, in the days following the election, the dollar continued to fall as a Biden win became more likely.
Vaccine
However, this week the dollar rose again in response to the positive news about the Pfizer vaccine against the coronavirus. ‘But in general it seems foreign exchange markets are accepting the story of dollar weakness for now,’ says Sammani. ‘How it eventually plays out very much depends on how quickly the US economy will recover though.’
Hurd also expects the dollar to gradually weaken over the next three to five years. One factor is the expected de-escalation of the trade war, but that is certainly not the most important one. ‘In part, Biden’s election is a one-off event that has already largely been priced in. And as far as trade is concerned, I don’t see us going straight back to the era before Trump. Biden is certainly not soft on trade, but he is more predictable. The chance of the trade war escalating is now much smaller.’
The main reason Hurd expects the dollar to weaken is the fact that the currency has lost its ‘yield support’, Hurd believes. ‘This makes the dollar less attractive to investors. I do expect a fairly mild dollar bear market though, because of course the dollar has already fallen sharply this year.’
The dollar could even pick up a bit over the coming months, Hurd believes. ‘The safe-haven appeal of the currency will remain. For the time being, we haven’t got rid of the coronavirus yet, and if there are more lockdowns or setbacks in vaccine development, this could slow down the dollar’s decline.’
EM benefits
A sustainable recovery of the global economy as a result of the arrival of a vaccine is likely to herald a rotation to more cyclical equities in Europe and emerging markets too, notes Hurd. Such a recovery trade will be negative for the dollar because it means that money will flow from US growth stocks to foreign equity markets.
UBS AM’s chief strategist Evan Brown is already preparing for such a scenario. ‘We have the strongest conviction in long-term dollar weakness and outperformance of emerging market assets,’ he says. EM currencies will benefit from the declining threat of import tariffs under a Biden presidency, he thinks.
Is there anything that can stop the trend of a weaker dollar in the medium term? Hurd doesn’t really believe there is. ‘If inflation suddenly rises sharply for a number of months in a row, the Fed could raise interest rates. That would create a lot of uncertainty in the markets and lead to a flight to the dollar. But this is definitely not our central scenario. A renewed escalation of the trade war could also lead to a renewed rise in the dollar. But I don’t expect this either.’