When it comes to the U.S. dollar, 2020 is likely to have a lot in common with previous years: Predictions of dollar weakness will ultimately be dashed. While foreign exchange markets are notoriously difficult to predict, the risks around the outlook are more balanced than the consensus forecast for an immediate weakening. Five key factors should support dollar strength in 2020: Favorable growth, interest rate differentials, elevated uncertainty, repatriation flows and dollar funding shortages.
U.S. growth differential will support the greenback: While the global economic and trade slowdown since 2018 has been one of the most severe since 2009 – on par with the 2012 and 2015-2016 slumps – its characteristics have differed. In particular, relative U.S. outperformance has characterized the most recent bout of global weakness. The fiscal stimulus from the Tax Cuts and Jobs Act and the Bipartisan Budget Act of 2018 provided the U.S. economy with a high degree of insulation against global struggles. That’s why it was able to outpace the rest of the G-7 nations by 1.6 percentage points (ppts) in 2018 and 1.3 ppts in 2019. While the effects of the fiscal stimulus will have fully dissipated next year, we can expect the U.S. to outpace every other G7 economy, with an average GDP growth differential of 0.8 ppts.
U.S. interest rate differentials should still favor flows into U.S. assets: While the relationship between real and nominal interest rates and the dollar has grown increasingly tenuous over the past five years, higher U.S. rates should still support a strong greenback in 2020. With the rate spread narrowing only modestly in 2020 – as the Fed proceeds with an additional rate cut and the European Central Bank remains on hold – this could exert some downward pressure on the dollar.
But with short-term interest rates across most developed economies unlikely to break much further below their effective lower bound, the asymmetric policy space will blur potential exchange rate implications. Therefore, it pays to view the recent narrowing of the spread between the U.S. 10-year Treasury yield and its German bund equivalent with a wider historical lens. As long as the spread doesn’t narrow much further, it should support U.S. dollar strength.
Safe haven flows will continue to support the greenback: While global economic activity may have shown some green shoots of rebounding, those remain sparse, and risks to the outlook remain tilted to the downside. In an environment prone to sudden policy disruptions – such as U.S. tariffs, Brexit and other geopolitical developments – global uncertainty is likely to remain elevated in the new year. So continuous safe-haven flows into U.S. assets will support dollar strength.
Dollar funding shortage: Disruption in the U.S. repo markets is also likely part of the strong dollar story. The Fed’s failure to provide enough short-term liquidity amid an overreliance on only four banks – unwilling to lend cash due to regulatory constraints – has created a shortage of dollar funding in the U.S. and abroad. The increasing cost of offshore dollars has coincided with periods of dollar appreciation. But even under the Fed’s new liquidity regime, the impetus for an oversupply in the market and weakening of the dollar isn’t present yet. That means the cost of dollar funding abroad is consistent with a stable dollar, not a weakening one.
Repatriation flows: One argument against dollar strength into next year is that a drop in repatriated U.S. firms’ foreign profits may remove a crucial support for the dollar. But this was probably never an important direct factor in boosting the dollar. Much of these earnings were already held in dollar-denominated assets and therefore exerted little influence on the dollar when repatriated. Further, the size of the flows is relatively small, around $660 billion in 2018, only around 10 percent of the spot dollar market’s size.
While reduced repatriation flows in 2020 will likely constrain stock buybacks, and thus lend less support to the U.S. equity market, the induced dollar effects will be minimal.
Medium-term anchors will reassert themselves in 2021 and 2022. Over the past 30 years, swings in the twin deficits – current account and federal budget deficits – have led exchange rate movements by about six quarters
With the twin deficits likely to gradually widen over the foreseeable future, we should expect to see downward pressure on the U.S. dollar. But contrary to the consensus view, this anchor will not reassert itself instantaneously. A rise in U.S. external funding needs will no doubt weigh on the dollar, but short-run macro policy drivers will more than outweigh structural forces in 2020.
Gregory Daco is chief U.S. economist at Oxford Economics USA.