Markets are very pre-occupied with trends in currencies even though it is very difficult to forecast what is going to happen with exchange rates. Currency markets certainly are the most tricky to forecast — stock markets tend to rise over time, while central banks are now providing enhanced forward guidance on the likely path of interest rates that extends out over a number of years.
On the other hand, numerous factors seem to impact currency markets, factors that can vary in importance over time.
There is no more important currency than the US dollar. As the dollar is a safe-haven currency, it tends to appreciate at times of stress in financial markets when risk-off sentiment dominates. It is also the funding currency of choice in markets given its liquidity, which adds to its tendency to appreciate at times of stress as borrowings are repaid.
Longer-term, it would appear that the trend is your friend in regard to the dollar. The currency appreciated in the 1990s, fell during the first decade of this century before appreciating over the past decade. As a result, the US dollar is now at elevated levels. The question is could the dollar be about to change direction again in the coming decade. Spotting such big turning points, though, is notoriously difficult.
Nonetheless, we could be in the midst of some key changes to the dollar’s medium-term prospects.
First, favourable interest rate spreads have been a key factor in supporting the dollar for much of the past decade, with the Federal Reserve pitching US rates considerably higher than in the other large advanced economies. This advantage has now largely gone. Furthermore, under its new policy framework, the Fed is more or less promising to keep rates at near-zero over the next few years.
Second, the past decade, starting with the financial crises and continuing up to the Covid-19 pandemic, has been characterised by subdued growth and quite a brittle risk sentiment. This has benefitted the safe-haven dollar. Given though, the amount of stimulus injected into economies this year and the extent of pent-up demand, there is scope for a period of strong robust growth and much-reduced uncertainty once the coronavirus subsides.
Third, if the opinion polls are correct, then a regime change is likely innext year.
It is not fully clear what a Democrat-controlled administration would mean for the dollar, but a continuing loose fiscal stance in a country with an already very large budget deficit, as well as a significant balance of payments deficit, would be a risk for the currency.
The US fiscal deficit is put at over 15% ofin 2020, the largest since 1945. The so-called twin deficits could return to haunt the dollar in an environment of close to zero interest rates, and where the demand for safe-haven currencies has abated.
is chief economist at