Deeper downside for the dollar?

The dollar has seen better days.

Is the US Dollar going to reach a level not seen since 2018?

 

In the past 124 trading days, only 46 has been in the green for the dollar index.

Many factors have catalyzed this risk off-trend, and unfortunately, I believe even the key fundamental strength for the dollar has slowly diminished away during this pandemic.

Inflation is the dollar’s demise

Inflation in the United States diminishes two things. A) The buying power of the U.S. dollar and B) Real bond yields. Both factors disincentivize investors to hold U.S. dollars. Furthermore, with the Federal reserve implementing a new tool specifically to combat low inflation, it all but guarantees that inflation will rise in the near future, diminishing the U.S. Dollar’s power.

Dollar printer.. go brrr…

US Federal Reserve's balance sheet

The Federal Reserve balance sheet stayed relatively unchanged from 2015 to 2020, dipping below 4.5 trillion near the end of 2020. However, due to the increase of asset purchases to stabilize the financial system, their balance sheet swelled up to 7 trillion at the start of August. The buying back of bonds increases the supply of U.S. dollars in the money market, decreasing the value.

Low-Interest rates have made it cheaper to hedge against the U.S. Dollar.

Many overseas investors, including myself, are pleased to hear dollar weakness as it entails, I will get more U.S. dollars when I convert my New Zealand dollars to fund my brokerage account. However, if I wanted to sell positions and covert it back into New Zealand dollars, chances are the U.S. dollar’s weakness will erase a majority of the gains made. However, with low-interest rates, institutional investors have found it cheaper to short the U.S. dollar to hedge their equity positions from further downwards pressure.

“Safe haven” trade has been given to Gold

We saw the U.S. dollar rally against other major currency pairs during the peak of the lockdowns in March as major investors sold off their risk-on assets to hold U.S. dollars. However, as the market reaches all-time highs, the U.S. dollar, with its almost guaranteed diminishing yield, has lost interest from investors in favor of Gold.

This is the main problem for the U.S. dollar. One of the only fundamental strengths that the U.S. dollar has had this year was when there was a rush to hold the greenback in the risk-off period we had in the middle of March/April. However, two things have changed since then:
• Market sentiment has favored Gold in Risk-off days
• “Risk-off “periods like March / April is likely not to occur again

Dollar struggles in the new normal

Coronavirus cases continue to pile up in India, United States, Australia, and Europe – however, investors have continued to plow money into the equity markets. To put this into perspective, cases in the United States have only worsened since the peak of the recessionary period in March / April. However, the NASDAQ is up nearly 30% year to date. If the market is a voting machine, it has voted that the new normal is the Coronavirus running rampant everywhere, including the United States. Therefore, anything better than that should boost equity markets. And can things can worse in the United States with regards to the Coronavirus?

The dollar is experiencing significant headwinds, both qualitatively and quantitatively. Investors do not want to hold it, future headwinds like inflation are destined to push it lower, and its only strength is slowly diminishing.

Bearish bets on the dollar are increasing…

Jack McIntyre from Brandywine Global Investment Management stated that “The dollar has been overvalued for a long time, and this might finally be a catalyst for a multi-year downtrend.” Furthermore, he said that “As we’ve seen before when valuations have been stretched, policy or economic shocks can quickly change the currency’s trajectory, and that’s what it seems to be happening thanks to the Fed’s swelling in the balance sheet, a surge in debt, and the way we handled the pandemic.”

…However is likely to hold its status as the reserve currency of the world

Liz Young, from BNY Mellon Investment Management, stated that what we’re currently seeing in the U.S. dollar “.. is a pullback..” and that “it is a little too extreme to think the dollar is going to lose its reserve status anytime soon.”

Bloomberg also stated that investors and traders are currently net short on the currency, with an increase in demand for puts options on the Bloomberg Dollar Spot Index, cementing a sentiment for a bearish trajectory possibly to a level not seen since 2018.