US Dollar Fundamental Forecast Talking Points
- The dollar ended the third quarter with a significant technical breakout, supported by strong fundamentals previously ignored
- Monetary policy forecasts show the Fed is making a clear effort to acclimate markets to an impending decline, which would be a turning point in the bank’s policy cycle
- If risk trends collapse, the Fed may have to delay its normalization plans; but the dollar also has a safe haven appeal that could benefit in most scenarios
We head into the last quarter of 2021 with an undeniable sense of change underway. The pace of global economic recovery from the pandemic-induced recession has slowed significantly. Central banks were beginning to relax their exceptional support structures, initially by “scaling back” their massive stimulus programs. In addition, financial spots have arisen in different areas of systemic importance such as the Chinese real estate market and another deadlock on the US debt ceiling. Such transitions bring uncertainty and often volatility. This is a likely boon for the US dollar given its liquidity and safe haven properties. Yet, as always, there are scenarios that could undermine the currency’s traction.
Post-pandemic recovery slows
The global economy may not have fully recovered from the impact of the brutal and severe recession caused by the pandemic in the first half of 2020, but it has certainly recovered quickly. With the budgetary and monetary support deployed by authorities around the world, the cooperation effort has proved remarkably effective. However, the scale of the external support implemented cannot be maintained indefinitely. Maintaining such policies would inevitably create points of instability such as runaway inflation and financial bubbles. In fact, the seeds of these vulnerabilities may already be sown; but officials are still aiming for a controlled landing.
As the global ship honors itself, we have naturally seen the pace of economic action slow down. This should come as no surprise as growth normalizes and indicators based on rates of change (such as GDP) inevitably plateau. However, this routine part of the cycle does not necessarily appease consumers, businesses and governments around the world who have indirectly used forms of leverage to weather the storm and profit from the recovery. As the global pace of growth slows, the sense of universal desirability fades; and capital begins to flow into these areas of the financial system with both the depth and weight to provide stable returns. While there will be some inevitable competition from the developed world, the United States appears to be a direct beneficiary of the pursuit of qualified risk. As an impressive benchmark, the FOMC raised its GDP forecast for 2022 to 3.8% in the September economic projection summary.
Graph 1: Composite PMI surveys of the main economies
Expected Fed Hikes and Community
A resumption of economic strength is a strong motivation for central banks to curb their extreme accommodation policies and this seems to be well underway as the last quarter of the year approaches. While not all of the major players are joining efforts to ease stimulus packages, a host of major players have acted, announced or hinted at a cut. While investors who enjoy the perception of unlimited support from these deep-pocketed asset buyers may not appreciate moderation, collective change can help reduce distortions in segments of the system. that can often lead to contagious financial events. For its part, the Fed closed the third quarter with a clear suggestion after its September policy meeting that the reduction plan would be announced at the next meeting, unless something seriously went wrong. In addition, President Powell has suggested that the reduction could end by mid-2022 and that the first rate change could come at the end of the same year. It’s relatively hawkish on the dollar.
Chart 2: Dollar DXY index and implied change in federal funds in 2022
Source: TradingView; Prepared by John Kicklighter
Always a haven of peace – with a few exceptions
If global policymakers are able to focus their efforts on stabilizing the economic expansion and shifting the risks held on their own records to the market as a whole, the assets of the greenback and the United States would be well positioned for take advantage of fundamental winds. Alternatively, there has been a huge amplification of risk over the past 18 months due in large part to the brutality of the tools available to officials to tackle the financial fire. An unintended but inevitable side effect of this effort has been to foster moral hazard – to take risks without worrying about the consequences of that exposure. As growth cools and market volatility increases, the scrutiny investors will place on their existing risks and any new exposure will increase dramatically. This assessment is overdue given the relentless push by speculative benchmarks like the S&P 500 and leverage measures like NYSE’s client margin hitting record highs. In the event that this critical review triggers risk aversion, the dollar’s safe haven status is well positioned to offer capital flight.
While the greenback is generally a safe haven candidate in most financial stress scenarios, there are a few likely prices that can cause capital to seek refuge elsewhere. The most significant localized risk to the US currency and its fiat assets would be a crisis arising from the national debt limit. As we enter the last three months of the year, the federal government has once again bargained for the debt ceiling. A government shutdown is a tangible scenario that we have not seen for a few years. Although this is a situation best avoided, it is not really critical. Missing payment on debt already incurred would be potentially catastrophic for the global financial system, let alone the US markets. Although still a very low probability, the scam in Washington, DC could still have troubling consequences such as a sovereign credit rating downgrade similar to Standard & Poor’s in the United States in 2011. We have justified the “risk-free” value still due to treasury bills despite this reduction, but it would be a very different situation if there was a second downgrade.
Chart 3: Risk spectrum for assets