Although uncertainty about the US election result might temporarily support the dollar, we expect it will continue to decline over the next few years given our forecast for loose fiscal and monetary policy.
- Although uncertainty about the US election result might temporarily support the dollar, we expect it will continue to decline over the next few years given our forecast for loose fiscal and monetary policy.
- The ~5% rise in the dollar following the 2016 election raises the question of whether this election will prompt a similar appreciation. (See Chart 1.) That initial move was arguably driven by safe-haven flows from policy uncertainty as well as by higher US yields reflecting expectations for expansionary fiscal policy and tighter monetary policy. Although the dollar weakened as safe haven flows reversed, that policy mix maintained the dollar’s strength in the years following the election. This policy mix was a (much) weaker form of the conditions that drove the dollar higher in the early 1980s. (See here.)
- As in 2016, we think that uncertainty could drive a short-term rally in the dollar, especially if the election outcome is contested. The most recent comparison for this outcome is the 2000 presidential election. The dollar strengthened about 2% and yields fell while manual recounts were tallied until November 26th. (See Chart 2.) If the 2020 election is contested, the same risk-off dynamics could provide support for the dollar until the race has a final result.
- Unlike after 2016, regardless of the election outcome we expect looser fiscal policy to be accompanied by easy monetary policy, a combination that usually precedes dollar weakness. (See Chart 3.) More specifically, we identify this loose policy mix as an expansion in the cyclically adjusted primary balance and a reduction in the real Fed Funds Rate. This policy combination increases domestic demand and widens the current account deficit while encouraging capital to flow from the US to markets with higher interest rates, both conditions for a decline in the dollar. (See Chart 3.)
- The consensus outcome of a ‘Blue Wave’ is consistent with our expectation for a weaker dollar. (See Chart 4). Intuitively, a unified government – with control of the Presidency, House, and Senate – has a higher likelihood of passing fiscal stimulus, which in turn can weaken the dollar if monetary policy is easy. On average, the dollar has depreciated by ~10% during unified governments in the four years following presidential elections since 1972. (See Chart 5.) Accordingly, we expect this outcome would probably be the least favourable for the dollar, even if the eventual fiscal stimulus may not be as large or timely as many appear to expect. (See here.)
- Even in the absence of a ‘Blue Wave’, we would still expect the dollar to weaken further, as the policy mix remained fairly loose and real yields stayed low to sustain the recovery. Although we anticipate that the election outcome will determine the extent of fiscal stimulus, and in turn the extent of dollar weakness, we think a loose policy mix that maintains low real yields will remain the key driver of the dollar. (See here.) This accommodative policy stance is common following economic slowdowns, and often, but not always, coincides with unified governments. (See Chart 6.) We consider the extent of fiscal stimulus to be an important factor for equity and bond markets as well. (See here.)
- We think fiscal and non-conventional monetary policies will play an increasingly important role in driving exchange rates with policy rates near zero among all G10 countries. One risk could be that the Fed tightens policy more quickly than expected due to inflation spurred by fiscal stimulus. While it is possible that fiscal stimulus could drive inflation beyond its former 2% target, we think the Fed’s average inflation targeting framework raises their inflation tolerance and the likelihood they keep rates near zero. (See here.)
- The same is true for inflation resulting from non-conventional monetary policy. But examining the short history of large-scale asset purchases, we think it is more likely that further expansion of the Fed’s balance sheet would weaken the dollar rather than spur inflation. (See Chart 7.) Higher asset purchases would signal the Fed’s commitment to keeping rates low as well as reduce the supply of risk-free USD-denominated assets, encouraging investors to rebalance portfolios to riskier assets, such as high-yield bonds or EM equities.
- Overall, we expect the dollar to continue to depreciate through the end of 2022, although we think the extent of its decline will depend on the extent of fiscal stimulus following the election. (See Chart 8.)
Chart 1: DXY & 10 Year Yield
Chart 2: DXY & 10 Year Yield
Chart 3: BIS Narrow Real Trade-Weighted US Dollar Index Vs Loose Policy Stances
Chart 4: Average Change In The DXY Following Elections
Chart 5: Average Change In The DXY By Outcome
Chart 6: Government Composition & Policy Stances
Chart 7: EUR/USD & Relative Y/Y Growth Rates Of Fed Vs ECB Securities Purchases
Chart 8: Change Vs US Dollar From Now Until End-2020 & End-2021 Implied By CE Forecasts (%)
Sources: Refinitiv, CE
Jonathan Petersen, Markets Economist, email@example.com