In times of uncertainty and stress, the U.S. dollar is the world's safe haven currency. But its continual ascent over this quarter may no longer be justified by economic fundamentals. The greenback is now overvalued.
The dog days of summer are often illiquid because trading volumes drop when people go on vacation; and the season is also subject to bouts of panic when the holiday calm is shattered by the inevitable surprise news event. This August's menu of woe includes the spread of the delta variant globally and the dash of fear that the pandemic recovery, which we seemed to be on the verge of, is actually dipping into a long drawn-out plateau. This noxious combination is keeping a firm bid under an already fully-priced dollar.
Meanwhile, the Federal Open Markets Committee (FOMC) is making noises that its monthly $120 billion bond buying program might be dialed down in the next few months. The perpetual worry among investors around the world is that stimulus may be withdrawn before the U.S. economy (on which everyone is somehow dependent) is fully self-sustaining. It's no surprise they think it best to head for the safety of the greenback, where they can sit out the imagined storm.
There is a limit, however, to how much these negative factors can contribute to the dollar's strength when economic conditions in the U.S. and elsewhere are undermining it. Kit Juckes, currency strategist at Societe Generale SA, points out inflation is principally a stateside narrative. The U.S. consumer price index (excluding food and fuel) has more than tripled this year to a 4.3% annualised level. In other developed economies, it's nowhere close. U.K. core CPI is at 1.8%; the equivalent euro area measure is at 0.7%; and Japan super core is -0.6%. Runaway inflation cannot be good for a currency, even one as mighty as the dollar.
The barometer of global growth is measured in the price of industrial commodities — oil, copper and iron ore, among others. All, especially the third, have all turned lower. That is inconsistent with the usual pattern of a strong dollar, which is reflected in higher commodity prices. It's all a bit illogical.
There were more mentions than usual of pandemic risks in the latest FOMC minutes. If the delta variant leads to widespread lockdowns, the prospect of any meaningful reduction in Fed stimulus could easily slip over the horizon again. With interest rates remaining low, there would be less reason to own hard dollars if the differential with other currencies doesn't increase.
Indeed, concern over Covid-19 resulted in a late change to the annual symposium of the world's top central bankers in Jackson Hole, Wyoming, scheduled to begin 26 August. It will now be a virtual event instead of the traditional in-person gathering at Grand Teton National Park.
Even if there is a reduction in the flow of monthly buying in the next few months, the amount of bonds in the system remains at record levels, with the Fed balance sheet climbing north of $8 trillion. That's a lot of dollars in the system, which means the currency's value should be lower not higher. There is no longer any shortage of dollars swimming about, as was the case in spring 2020. Massive currency swaps with foreign central banks and vast ongoing QE have seen to that.
An interest rate rise — which would make the dollar more valuable — still isn't likely until 2023. And with Jackson Hole now to be held remotely because of virus worries, the probability remains high that Fed Chair Jerome Powell pushes any policy decisions out to the next FOMC meeting on 23 September. Either way, there is simply too big a time lag between any prospective taper of quantitative easing and the Fed funds rate actually ever being raised high enough to justify further flight from the euro or other currencies that lag behind in the stimulus reduction process.
Furthermore, the stronger dollar certainly doesn't tally with 10-year U.S. Treasury yields at 1.23%. They are 50 basis points lower since the start of April — with the yield spread premium narrowing versus other global bond markets.
It doesn't make sense that the dollar keeps stretching richer. And eventually reason will catch up with it. Not everything, all the time, should result in the buck rising. It's overpriced. Time for a bit of mean-reversion.