Outlook on the US Dollar

2020 is an exceptional year in almost every sense. The year has taught us many things. It has not only changed the way we live and think but also the way we invest.

In fact, the year has made us acutely realize “change is constant” is going to be the norm which most of us have to adhere to stay relevant. These aspects are reflected in the movement of the US dollar.

One of the crucial changes that investors cannot and must not ignore is the changed outlook on American dollar (USD). The Greenback is the universal tender. It has been volatile in the past five years. After hitting a high of 102 in January 2016, the US dollar index—a basket of six currencies— came down to touch 88 in January 2018. It recovered to 99.4 by February 19. It quotes around 90 now, just above the low it hit in early 2018. The index is used to indicate the value of USD in the context of other major currencies in the world.

US Dollar Index (DXY) during Republican and Democratic regimes. Click to enlarge the chart.

Now, it is important to understand this weakness in the dollar in conjunction with what has happened. In recent times, countries have approved immediate use of COVID-19 vaccines. Besides this, the coming of the US President elect Joe Biden allays concerns of prolonged trade wars. Even as these two big concerns are sufficiently addressed, the American dollar is weak.

A change in the outlook on the US dollar is a big deciding factor in the way money is allocated to different asset classes. Changing macro-economic landscape must be studied before taking any step in this direction. Globally, investors are mulling of shifting capital away from the US dollar to risky assets such as emerging market equities, real estate, commodities and other physical assets.

Investors need to understand the factors which strengthen or weaken the US dollar. They should stay away from speculative interpretation or exaggerated view of existing realities.

Investors should focus on macro-economic factors. They serve well in understanding future trends to a certain extent. For instance, when a recession hits, investors prefer safe-haven investments. Consequently, the demand for the US dollar and the US treasuries go up. No wonder, the US dollar strengthened in the early part of 2020. This was largely due to rising COVID-19 cases and subsequent lockdowns to contain it. But as countries developed a concrete plan to distribute COVID-19 vaccines on a mass scale, the rally in the US dollar fizzled out. Investors must focus on recovery and growth in the US markets. If the recovery and growth of the US outpaces the rest-of-the-world’s recovery and growth, then the US dollar may strengthen.

There are a few factors which have bearing on the demand for the US dollar. In the early months of 2021, trade talks are expected to catch up. This will improve the demand for US dollar. Despite BREXIT, the Euro is a strong alternative to the USD as a trade currency. Also there are few takers for the Chinese RMB for trade. These factors may improve the demand for the US dollar. But there is another aspect to the current price of the US dollar. Experts point out the overvaluation of the USD compared to other global currencies. Foreign brokerage Goldman Sachs expects the US dollar to depreciate at least 30 percent in the next three years. There can be more to the downside. Though there is disagreement over the quantum of possible depreciation in the US dollar, there is an agreement on depreciation of the USD in future.

Investors must note that prolonged period of weak US dollar and negative real interest rates may keep investors away from dollar-denominated assets. Commodities including gold are expected to do well. Also emerging markets equities are expected to do well. The search for high-yield investments may result in larger allocation of money to risky assets compared to conservative options like high-quality debt which provides low yields.

In the lights of these facts, investors must realign their portfolios. Instead of chasing what has done well in the past, investors must construct a diversified portfolio keeping in mind their financial goals. Such a portfolio is likely to arrest any fall in portfolio returns.

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