HERE IS THE tale of the dollar so far in 2021. It came into the year on a declining trend. A lot of people were mildly chary of its prospects. The gist was that people had bought a lot of dollars last year. They might wish to sell some. There has since been a dramatic upward revision to forecasts for GDP growth in America. This has been mirrored in sharply rising Treasury yields. Growth upgrades; higher interest rates; both are good for currencies. The result has been a stronger dollar.
It is not sufficient for a strong dollar that America does well; others must also be doing badly. “If the US economy grows incredibly fast and nowhere else does, the dollar will go up,” is how Kit Juckes of Société Générale, a bank, puts it. The question is: can it keep going up and for how long? The dollar usually provokes strong feelings in the currency fraternity. It is either loved or hated. That is not the case now, which is remarkable. There may be a strong-dollar story. But there is no really strong story about the dollar.
To understand why, consider first the important drivers of currency moves: trade flows, relative interest rates and risk appetite. Trade flows track the underlying demand for a currency. If domestic interest rates rise relative to foreign ones, that attracts speculative capital inwards, supporting a currency. Shifts in risk appetite can overwhelm these fundamentals. Indeed that was the story in 2020. Last March, when suddenly the priority was to have cash, the cash that people wanted was dollars. The DXY index, a weighted average of the dollar’s exchange rate against six other widely traded currencies, rose sharply in mid-March, as covid-19 panicked markets. The Federal Reserve responded by opening swap lines with other central banks to ease the dollar shortage. Then, over the rest of the year, the dollar declined, as risk appetite revived.
The greenback’s bounce-back this year is more about interest-rate differentials. Here the story gets a little frayed. The interest rates that you would normally think of as mattering for speculative currency flows are short-term rates. But central banks are not for moving those soon. So bond yields have become a signifier, since they in part reflect the as-yet-distant tremors of moves in future short-term rates. Bond yields in turn are responding to growth expectations. The dollar responds by moving higher.
After all, what currency would you swap it for—the euro? America’s economy is roaring back, while much of euro-land remains closed, and the distribution of vaccines has been (how to put it charitably?) sluggish. You can make a case that the Federal Reserve will have to tighten monetary policy sooner than it thinks. But the European Central Bank looks set to keep interest rates near zero indefinitely. The same goes for the Bank of Japan. Britain’s vaccination programme has been a success, which helps explain the rising pound. But Britain remains locked down and its economy is still suffering. Rising crude prices have pushed up the currencies of big oil producers, such as Canada and Norway. But beyond these, there are few currencies you might prefer over the greenback.
The dollar seems likely to rise a bit further in the near term. “There are a lot of stale short-dollar positions,” says George Papamarkakis of North Asset Management, a hedge fund. Speculators who have a bearish view of the dollar have already sold it short. If the currency keeps rising, they may be forced to buy it back. Another factor in the dollar’s favour is that risk appetite is less ravenous than it was. Equity markets are choppy. The dollar might be the least-worst place to sit out the volatility. And if the financial markets suffer a full-scale tantrum, the greenback could benefit from a flight to safety.
Later in the year, though, there is a case for a mildly weaker dollar. A big part of that story is that a booming American economy will lead to a wider trade deficit: strong demand in America will spur activity elsewhere. Asia is already doing well. Europe is lagging but will enjoy an upswing once vaccination rates pick up. Risk-taking would then revive. “When the US is doing well, and also bringing the world with it, there are more interesting places for investors to put their money,” says Mr Juckes.
As the days grow longer, 2021 might start to look less like early 2018, when a faster pace of interest-rate increases in America drove up the dollar, and more like 2017, a year of broad global growth and a falling dollar. The story of the greenback in 2021 could yet have a twist.
This article appeared in the Finance & economics section of the print edition under the headline “Winter’s tale”
Source: Finance - economist.com
