Why Covid-19 aid, inflation fears hold the key to the dollar’s future
5 min read . Updated: 18 Mar 2021, 04:57 PM IST A $1.9 trillion spending package and a faster-than-anticipated vaccine rollout are buoying growth forecasts—and inflation
The U’s economic prospects look brighter than those of many other countries—and that has driven an unexpected dollar rally this year.
Investors thought the greenback would weaken during a coordinated global rebound from Covid-19 lockdowns. Instead, the U.S. stands apart from the rest.
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The flip side of this exceptionalism is a growing fear of higher inflation that could eventually reverse the dollar’s fortunes, according to some investors.
The dollar has risen nearly 2.5% against the currencies of the U.S.’s major trading partners since early January. Some had predicted declines of up to 20% in 2021.
The big difference is the passage by Congress of a $1.9 trillion spending package, which is delivering $1,400 checks to many American households.
However, the same U.S. relief bill is also stoking inflation fears. The money will hit the economy just as a wave of pent-up demand and cash saved by some households during lockdowns could be unleashed. Secondarily, it will add to America’s budget deficit—a measure of how much government spending exceeds revenue from things like taxes—and debt burden.
“Higher inflation in any country is typically currency negative," said Peter Boockvar, chief investment officer at Bleakley Advisory Group. He added that the dollar will also be challenged by rising deficits.
Mr. Boockvar has increased investments in commodities and moved money into Asian emerging-market stocks in a bet that the dollar will weaken and inflation will rise.
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Fears of rampant inflation have gone unfulfilled for years. The U.S. has had low and stable inflation for nearly three decades.
For many investors, the scale of the government spending is what makes this time different. Even a left-leaning economist like former Treasury Secretary Lawrence Summers has raised concerns that the spending risks provoking sharp inflation.
“This latest relief bill is really quite extraordinary: We’ve become numb, almost, to these very large numbers," said William Dinning, chief investment officer at Waverton Investment Management.
He doesn’t expect “some sort of existential crisis for the dollar." Mr. Dinning is buying hedges that pay out when U.S. stock-market volatility jumps, rather than taking outright positions against the dollar.
Treasury investors are betting that inflation will jump in the near term and then fade. One theory why inflation hasn’t stuck in recent decades is to do with a lack of wage bargaining power in labor markets and global free trade. Advances in technology have also held down prices globally.
Some of these so-called disinflationary forces are losing their power or going into reverse, according to Dario Perkins, a global macroeconomist at TS Lombard, though not quickly. “These are things that change very slowly over time," he said.
Investors who are wary about inflation returning are looking at the scale of spending and borrowing combined. The budget deficit hit 14.9% of gross domestic product in 2020, the highest level since 1945. It was forecast to fall to about 10% in 2021 by the Congressional Budget Office, but that excludes the Covid-19 aid package.
Some investors are troubled by the amount of Treasurys being bought by the Federal Reserve, which creates dollars to do this. They see its recent bond buying as different to the quantitative-easing programs since the 2008 crisis.
Chris Brightman, chief investment officer of Research Affiliates, believes the current Fed bond buying is turning into an experiment in debt monetization, which is when the central bank prints money to directly fund a government’s spending.
“The Treasury is spending more than it collects in taxes, it issues debt to cover the difference and the Fed buys a goodly amount of that debt," he said.
Between 2010 and 2014, the Fed bought about 40% of the extra debt issued by the U.S. government and doubled its share of Treasury ownership to 18.6%, according to the Securities Industry and Financial Markets Association, a trade body. When government borrowing grew sharply last year, the Fed bought more than 55% of the new debt and its ownership share rose from 13% to 22%.
Mr. Brightman said he thinks printing money to fund direct cash handouts could end with a loss of U.S. fiscal discipline: Once the government decides that the Fed can effectively send checks directly to people’s bank accounts, it becomes hard to stop.
That would invite high and volatile inflation: Bad news for stocks, bonds and the dollar, he said. One response is to borrow in dollars and invest in real assets and resources companies, he added.
At the same time, the U.S. current-account deficit is growing as spending on imports is increasing relative to income from exports. A growing trade deficit means the U.S. needs foreign exporters to recycle dollars back into America through investing or lending. Twin trade and budget deficits can weaken an economy and leave its currency vulnerable.
To be sure, when it comes to funding trade and budget deficits, the U.S. has a big advantage because the dollar is the world’s most commonly used currency. That generates greater demand for Treasurys than for other countries’ debt.
However, demand from private investors, including foreign buyers, appears to have weakened recently. Foreign investors are still the biggest owners of U.S. public debt, but their pace of buying slowed last year and their collective market share fell from 35% to less than 30%.
Treasury yields have risen sharply this year as selling has pushed down prices, but yields are still at historically low levels.
“High debts and deficits don’t matter too much when interest rates and yields are low," said Mark Dowding, chief investment officer at BlueBay Asset Management. U.S. interest costs as a percentage of GDP are very low, particularly if you consider only the cost of servicing the debt that isn’t owned by the Fed.
This story has been published from a wire agency feed without modifications to the text.
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