So far, 2020 has been a volatile year for financial markets, and the currency markets have been no exception. The US dollar advanced nearly 9 per cent in the first quarter before giving back almost two-thirds of its rally as of the middle of August and it has since continued to trade sideways. 
Conversely, after declining nearly 5 per cent at one point in the first quarter, the euro was up 11 per cent from its March lows, while the Australian dollar fell 18 per cent in the first quarter and has since rallied 25 per cent.
The dollar's first quarter rally was driven by four factors. The first was the path through which the pandemic impacted the world. China was hit first, then Korea, and their economies were the first to slow. Next came Europe, notably Italy and Spain, before it finally reached the US. During this initial phase, the dollar strengthened.
The second factor was the higher level of US. interest rates compared to developed markets, and even some emerging markets, while the sharp flight to quality in March also supported US dollar appreciation as investors focused on capital preservation by buying safe-haven Treasuries.
Finally, the extraordinary income shock caused by the pandemic created severe financing stress globally, and in this environment there was a desperate scramble from companies – even high-quality ones – to find US dollar financing to roll over existing obligations until revenue normalised.
Changing picture
So what’s changed? In recent months, these four factors have largely reversed. Firstly, the pandemic has since stabilised in Asia and Europe, and it is the US recovery which is now lagging those recoveries. In particular, the acute “second wave” in the US is amplifying the growth lag between the US and the rest of the world.
The US also no longer offers higher rates of interest than other regions. The Federal Reserve slashed interest rates to zero in response to the crisis, so there is no longer an advantage to holding dollars relative to other markets. The Fed also pursued a large range of unconventional policies to expand the supply of money and credit for the economy. It has succeeded in not only reducing the price of money (interest rates) but has also succeeded in rapidly expanding the supply of money, both of which are negative for the dollar.
The flight to quality is also reversing as the pandemic stabilises and confidence returns. Finally, the Fed went out of its way to alleviate dollar-funding pressures with the expansion of dollar-lending facilities at the height of the crisis. As the negative growth effects of the virus subside and the global economy recovers, the US dollar is likely to weaken further, particularly against the more growth-sensitive currencies of emerging markets, now that funding pressures have been relieved.
Long-term problems?
The above are short-term issues, sparked by the extraordinary events surrounding the pandemic, and it could be the case that any retrenchment for the dollar is short-lived.
However, there are some longer-term trends that also cloud the dollar. The first one is political. Policymakers have effectively crossed the Rubicon with respect to Modern Monetary Theory (MMT), and alongside a rapid expansion of the fiscal deficit, the Fed has commensurately expanded its balance sheet.
Through the second quarter, US real personal income grew at its fastest pace ever. While the US was experiencing its worst recession in nearly 100 years, income growth would have suggested the economy was booming. The Fed provided all the money needed for the government to send out the support that the economy was screaming out for, but while it was necessary, it is nonetheless a longer-term negative for the dollar. Moreover, the current polling leader for the US presidential election, Joe Biden, is campaigning on a platform to raise corporate taxes. Just as the lowering of taxes boosted growth and the dollar in 2018, an increase in corporate taxes in 2021 will likely discourage capital inflows into the US, hurting the dollar.
Meanwhile, the political winds in Europe and China have moved in different directions. The eurozone has taken an important step toward fiscal union. Germany has finally gotten off the fence and recognized the need to help member states without conditionality, offering to assist the hard-hit countries of Southern Europe with grants and not just loans.
In the same way that New York and California taxes moved seamlessly through the federal government to help states ravaged by hurricane Katrina, Europe has formalised a similar mechanism for the Covid-19 crisis. This is a pivotal change for Europe, a step toward fiscal unity, and a positive for the euro. Meanwhile, Chinese authorities have taken a much more measured approach to using monetary policy to respond to the pandemic. In relative terms, US monetary policy is far looser than Chinese monetary policy, presenting another negative for the dollar.
Geopolitics aside, the second factor that has turned negative for the dollar is the more structural impact of the virus itself. While a variety of factors explain why some countries experienced more significant outbreaks than others, one common factor appears to be the size of the service sector.
Covid-19 cases per 1 million population
Source: Macrobond. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
This relationship makes sense considering the service sector relies on interactions between people, providing more scope for transmission – and the US has one of the largest service sectors in the world.
Unlike any recession post-second world war, the current recession is primarily a services sector recession. As the virus subsides in response to treatments, supplies, and ultimately a vaccine, the service sector will recover, and unemployment will decline. However, the impact of the virus on the economy will last well beyond the development of a vaccine. We are learning to what extent employees can operate from home. We also are finding other ways for interacting, re-evaluating commercial real estate needs, and seeing restaurants operate differently. These changes, and others like them, mean there are service sector jobs that are simply not coming back, and that should hurt the US more than other economies.
The US might have to contend with an elevated unemployment rate for longer until those individuals find different jobs and different training for different industries. That is a reason for the Fed to be somewhat easier relative to other central banks around the world, which should weigh on the dollar.
Both long-term factors point to further weakness over the medium term. Admittedly, the US current account has not shown the erosion in competitiveness that marked the 1980s and 1990s dollar bear markets, and it retains its leadership position in certain markets – like tech – which will support its companies and thus its currency. However, these factors are more likely to limit the degree of US dollar weakness than change the overall negative path for the dollar ahead. It’s been a near decade-long bull run for the dollar, but for now, that appears to be at an end.
Anujeet Sareen is portfolio manager of the Legg Mason IF Brandywine Global Income Optimiser Fund at Brandywine Global. The views expressed above are his own and should not be taken as investment advice.