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King Dollar Is Abdicating and That's OK

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The premium of U.S. interest rates to those in Europe and Japan has largely disappeared as Jerome Powell’s Federal Reserve cut short-term rates to near zero.

The premium of U.S. interest rates to those in Europe and Japan has largely disappeared as Jerome Powell’s Federal Reserve cut short-term rates to near zero.

Photo: pool/Reuters

There are many reasons to expect a weaker U.S. dollar next year and perhaps for longer, but none more important than the new policy stance of the Federal Reserve.

The U.S. dollar briefly rallied in March due to its haven role in investment portfolios. Since then, it has dropped around 12% against a trade-weighted basket of currencies as the U.S. turned out to be even harder hit by the coronavirus pandemic than most major economies.

As vaccines are rolled out and the global economy snaps back, this trade won’t necessarily run in reverse. Rather, currencies of countries that export commodities and manufactured goods are likely to keep strengthening against the dollar, as would be seen in a typical global recovery. Some Asian exporters already are quietly intervening to limit their currencies’ rise.

But this time, reasons to expect a weaker dollar run even deeper. For several years before the pandemic, U.S. interest rates on both the long and short ends of the yield curve were substantially higher than in Europe and Japan—a major source of strength for the U.S. currency. That premium has largely disappeared, though, as the Fed lowered short-term rates to near zero and launched a new round of asset purchases. The yield on 10-year U.S. Treasury notes has fallen from almost 2% at the start of the year to around 0.93% now.

Granted, that is still well higher than the 0.02% and minus-0.58% yields on 10-year Japanese and German government bonds, respectively. But real yields in the U.S. are in fact lower on an inflation-adjusted basis, points out markets economist

Simona Gambarini
of Capital Economics. In the U.S., the core consumer-price index was 1.6% higher than a year earlier in November. That compares with slight deflation in Japan and the eurozone.

This gap in real rates is unlikely to narrow soon. After all, the Fed pledged in August to let inflation run above its 2% target for an extended period and not to respond to falling unemployment with pre-emptive rate increases. Meanwhile, peer central banks around the world continue to target inflation rates of around 2% while falling well short of that.

If markets take the Fed at its word, they won’t bid up the dollar as they normally might in response to robust inflation or growth data out of the U.S. This is why TS Lombard economist

Steven Blitz
calls the new framework an effective end to the traditional “strong dollar” policy of the U.S. government.

Consider, for instance, the likely market reaction to a large stimulus package early in the Biden administration. Big doses of deficit spending are typically seen as dollar-negative because they mean the U.S. will have to import more foreign savings. But stimulus could be seen as dollar-positive if it successfully boosts U.S. growth. This time, however, the Fed has essentially pledged not to lift rates pre-emptively in response to positive economic news, so a big stimulus package is likely to be unambiguously negative for the dollar.

None of this needs to be bad news for investors. As most assets are priced in dollars, a weaker dollar often means higher asset prices on everything from stocks to commodities to emerging-market bonds. Investors whose net worth is concentrated in dollars should make sure they are diversified, for example by not hedging the currency exposure on their foreign equity holdings, says

Brian Rose,
Senior Economist, Americas at UBS Wealth Management.

The perennially strong dollar may be a thing of the past. Investors are unlikely to miss it.

Write to Aaron Back at aaron.back@wsj.com