Investor confidence that the Fed’s new inflation framework, which allows for inflation overshoots and leads to lower real yields through a ceiling on nominal yields, has been a defining element of the near-consensus U.S. dollar bearish narrative.
While at this stage it is just conjecture as to what the new united government wants to do, it is reasonable to expect another round of COVID-19 relief. Action beyond COVID-19 relief will then depend on a combination of political will and timing, as support for these programs should be less homogenous across the party. Regarding timing, if Congress uses reconciliation to pass COVID-19 relief, reconciliation will not be available again until fiscal year 2022.
Details of additional spending aside, the presence of additional stimulus should lead to a reassessment of the U.S. fiscal-monetary policy mix. To be clear, we are still in the early stages, so it would be premature to call an end to the dollar’s downtrend, especially with the absolute level of yields still very low and the Fed’s tolerance for rising yields untested. Nevertheless, the delayed blue wave represents support for the U.S. dollar, especially against low-yielding currencies and particularly during the second half of the year when COVID-19 is hopefully in the rearview mirror and focus turns to potential Fed QE tapering and global growth.
As it pertains to the U.S. dollar, there are two elements to the relationship between growth and the dollar. The first element is the global one—the dollar is widely accepted as an anti-cyclical currency. As such, growth upgrades are associated with dollar downgrades. The second element is the growth gap between the U.S. and the rest of the world. To the extent that U.S. fiscal spending lifts U.S. growth more than global growth, the dollar should appreciate as we saw in 2018 after the Tax Cuts and Jobs Act.
In regard to nominal yields and the dollar, the convergence of nominal yields was a key factor behind the dollar’s losing streak last year. However, there is very little space left for further nominal convergence. Further, U.S. 10-year yields have already doubled from their pandemic lows, so one could argue that the tide is turning.
To be fair, the dollar bearish argument, as it relates to the Fed’s new framework, also stems from real yields. To this point, there is further room for the dollar to fall on a real-yield differential basis than a nominal one. This fact, among others, is a reason why the dollar’s downtrend could continue in the near term. But it has to be acknowledged that real yields, and nominal yields, are moving back in favor of the dollar. | |
| HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT: | |
- Today House Speaker Nancy Pelosi is expected to request unanimous consent in the House on a resolution urging Vice President Mike Pence to invoke the 25th Amendment and remove the president from office. Failing this, Pelosi is then expected to bring impeachment papers to the floor, with a vote likely to come Wednesday. The Senate is currently on recess, and sending the Article of Impeachment may be delayed in order to allow Biden to address his legislative priorities first.
- On the virus front, Pfizer and BioNTech have raised their vaccine production target this year to 2 billion from 1.3 billion. Dodgers Stadium will switch from a testing facility to vaccinating this week, and a World Health Organization team will arrive in China this week to investigate the origins of the virus.
- The U.S. yield curve continues to steepen, with the 3-month to 10-year curve hitting its steepest point since late March. The 10-year yield is also at its highest level since March 2020. The rising in long-end rates partly reflects rising inflation expectations as markets anticipate another round of stimulus.
- The U.K. services sector has been hit by Brexit. As a reminder, the Brexit trade deal is a skinny deal that did not include trade in services, including financial services. Data on daily stock trades to EU financial centers on Jan. 4, the first business day after Brexit went into effect, showed a 6.3 billion euro drop in volume. This loss should put extra urgency behind U.K. negotiation efforts on equivalency talks, but with the EU gaining business, the EU is unlikely to feel the same sense of urgency. This example is one of many expected over the coming months that will illustrate how Brexit, with a deal, is still fundamentally negative for the U.K.
- Silvana Tenreyro, who is a member of the Bank of England’s Monetary Policy Committee, has stated that work on negative rates is in progress, with no further details.
- U.S.–China tensions continue to escalate, this time through the U.S. relationship with Taiwan, as Secretary of State Mike Pompeo declared all contact guidelines, which have been in place for decades regarding relations with Taiwan, null and void. U.S. Ambassador to the United Nations Kelly Craft will not visit Taiwan this week, a visit that challenges China’s “One China” policy. For China’s part, the country has expressed outrage but isn’t likely to overreact with the Biden administration set to take over shortly.
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