A Pause in the Dollar Bear Market

Currency dynamics can seem complex and obscure, but they often play a critical role in portfolio returns. Indeed, their impact on key factors, such as inflation and commodity prices—although frequently overlooked—can determine potential international allocations and portfolio positioning to help maximize performance.

Lately, the dollar’s shifting value has caught investors’ attention again. From its lows during the 2008 financial crisis and Great Recession, the dollar clawed back against a basket of major currencies—and hit prior-cycle highs in the two years leading up to March 2020. However, with the onset of the pandemic and policy moves that slashed interest rates back to near zero, along with trillions in stimulus, the dollar weakened considerably last year.  

So far in 2021, we’ve seen a reversal. The U.S. Dollar Index, which tracks the value of the dollar against a broad spectrum of major world currencies, has climbed nearly 3%. Why? New fiscal stimulus and widespread vaccine distribution have bolstered expectations for U.S. growth, while other regions continue to struggle with their pandemic response, translating into relative strength for the dollar. Real interest rates in the U.S. have also risen, offering further support.

Does this spell the beginning of a new dollar bull market? We don’t think so. Rather, we view the dollar’s retracement as a mere pause in a broader bear market for the currency. Here’s why: 

• The difference between U.S. economic growth and other nations is likely temporary. With the exception of China and the U.S., many countries have been lagging economically, primarily due to missteps in vaccine rollouts and economic reopenings. However, their recoveries should get back on track eventually, even if peak growth gets pushed into 2022.

• Ballooning “twin deficits” in the U.S. will likely weigh on the dollar, longer term. In January, the U.S. logged its second biggest trade deficit ever, at $68.2 billion. Meanwhile, federal fiscal budget deficits are expected to run between 12% and 15% of GDP for a second consecutive year. In the five years prior to 2020, deficits were typically between 3% and 5%. In addition, U.S. government debt as a share of GDP is closing in on 115%, the highest since World War II.

• The dollar faces headwinds abroad. First, we anticipate a shift in the U.S. government’s focus, from stimulus to regulation and higher corporate taxes, which has historically suppressed foreign direct investment. Second, competition looms from other reserve currencies, notably China’s renminbi.

To track the impending direction of the trade-weighted dollar, a measurement that emphasizes exchange rates relative to currencies most widely used in international trade, we recommend that investors watch two-year real-yield differentials vs. major U.S. trade partners. Investors may also want to consider focusing international exposure in their portfolio on countries where near-term dollar headwinds are more modest, such as Japan, the UK, Canada, China and Australia.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 29, “A Pause in the Dollar Bear Market.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.