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Tough times ahead for the dollar but it won't collapse as do many expect!

 

The dollar index DXY which measures the greenback against a basket of currencies is down 10% from its March high, and many analysts are calling for a 50% crash to come, in this article, I will assess some of their arguments, and I try to lay out different factors that could impact the dollar going forward.

One of the predominant arguments of dollar bears is that the US has a twin deficit( current account and fiscal budget deficit) that was one of the reasons why Trump got elected in 2016, but the deficit is widening even more due to the Covid 19 crisis. but that's not something new, the US has run deficits for decades now, and doesn't seem that's impacting the exchange rate, the reason for that is because the dollar still the world reserve currency, and whenever financial conditions are tightening, it will act as a safe haven asset.

Second, is that the US no longer offers the advantage of higher yields, well is it really?
after the Covid 19 outbreak, while the FED has slashed rates to near zero, the US still enjoys higher yields relative to  Europe, Japan, or Switzerland where rates are negative. one of the reasons for the recent decline is the readjustment of the value of the dollar relative to its yield differential against other currencies that their Central banks didn't cut rates because they were already at the lower bound, instead, they went with more unconventional tools like Quantitative easing. but we can argue that's already priced in.

And that leads us to the final argument, which that Europe will recover faster than the US, a lot of this euphoria was driven primarily by the EU recovery fund. and to be fair I think in the long term it will change drastically the perception of Europe from outside, but my point here is that it will not solve the structural problems of the European Union.

So am I dollar bull well it depends,(is that sounds like a typical analyst answer!) maybe so, but let's talk about the Dollar smile theory.

The theory says that when the US economy is outperforming the rest of the world the dollar will strengthen and vice versa, but in times of a global recession and uncertainty the dollar will benefit from its Safe haven status, as it did in March, but where are we now in the cycle? now we are at the beginning of the economic cycle, and ROW growth is expected to outperform the US in 2021, especially in Asian markets, that's driving commodity prices higher and any good news for risk assets would hurt the dollar, that's why I think we're going to see more selling in the coming few months especially with improving risk appetite following the vaccines headlines but once the US start showing signs that's it's recovering faster than Europe, and investors reassess their rate hike projections, that's would be the turning point for the king dollar.

--- Written by Halim Haddad,


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