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The United States’ post-war record GDP contraction in Q2 of 9.5% qoq and the Dollar’s recent depreciation have been making headline news but some perspective is required.
The US GDP contracted about 10.6% in H1 2020, far more than in China (+0.6%) and South Korea (-4.6%). However, of other economies which have so far released Q2 data – including the Eurozone’s four largest economies, Mexico and Singapore – all posted larger rates of contractions in H1 2020. The UK’s GDP likely shrunk more than twice as much whilst France (-19.0%) and Mexico (-18.3%) fared only marginally better.
Moreover, GDP in the US outperformed in H1 2020 despite GDP growth in 2019 (+2.4%) being materially stronger than in Mexico (-0.1%), Italy (+0.3%), Germany (+0.6%), Singapore (+0.7%), the United Kingdom (+1.5%), France (+1.5%) and Spain (+2.0%).
How major economies will perform in Q3 in the context of a rise in the number of local or national covid-19 cases and some countries having (partially) frozen or re-tightened national lockdowns is up for debate. The outlook for Q4, which for Western countries will mean colder weather and a potential increase in covid-19 cases, is even more uncertain.
The Dollar’s depreciation in the past six weeks from a strong level is mainly due to successful central bank policies to address imbalances in its supply and demand and a cyclical rotation out of Dollars into other FX reserve currencies, including the Euro.
As a result, the share of Dollars in the world’s central bank FX reserves, which has hovered around 62% in the past two years, may have fallen slightly in recent months while the share of Euros (20%), Sterling (4.4%) and Swiss Franc (0.15%) may have increased marginally.
However, we do not think that FX price action in the past couple of months, including the Euro’s appreciation to multi-year highs, points to the beginning of a structural and permanent shift in the currency composition of central banks’ FX reserves.
In the same way that apocalyptic forecasts in the past about the Eurozone and Euro have failed to materialise, current forecasts of the Dollar’s demise as the world’s number one reserve currency are at best extremely premature, at worst unfounded in our view.
The Dollar’s recent depreciation and United States’ post-war record GDP contraction in Q2 have been making headline news with some analysts already predicating the demise of the Dollar as a reserve currency. We would argue that such forecasts have little basis and that some perspective is required.
United States GDP contracted 9.5% quarter-on-quarter in Q2 2020 – that’s far from extreme
Advanced data released last week by the Bureau of Economic Analysis show that GDP contracted by a seasonally-adjusted annualised rate of 32.6% quarter-on-quarter in Q2, the fastest quarterly rate of contraction in the United States since World War Two. This is all the more remarkable as since the 2008-9 great financial crisis US GDP growth had become increasingly stable, with our measure of GDP “volatility” hitting an all-time low in Q4 2019 (see Figure 1 and US GDP Growth – One Extreme to Another, 26 June 2020). However, the pace US GDP contraction in Q2 and the first half of the year was not particularly acute relative to most other major economies.
For starters, unlike most other major statistical offices, the BEA releases annualised GDP data which at first glance make US growth rates appear more extreme. In simple quarter-on-quarter terms US GDP contracted “only” 9.5% in Q2 (see Figure 2). More importantly, we would argue that one should compare economies’ aggregate GDP data for Q1 and Q2 given that countries commenced and started to unwind their national lockdowns at different times.
Figure 2 shows that in Q2 the US GDP was about 10.6% lower than in Q4 2019. The majority of other economies or economic blocks which have so far released Q2 GDP data – Mexico, Singapore, the Eurozone (including Germany, France, Italy and Spain) – all posted larger rates of contractions in the first half of 2020. In particular Spain’s economy shrunk more than twice as much (-22.7%), as did the United Kingdom’s according to our estimates, whilst France (-19%) and Mexico (-18.3%) fared only marginally better. China and South Korea are so far the only two major economies to have posted stronger GDP growth rates in H1 2020 than in the United States.
Based on UK composite PMI, retail sales and other macro data we estimate that UK GDP growth accelerated to a record-high 10% month-on-month in June. However, this would still imply that UK GDP contracted a record 20.6% qoq in Q2, according to our estimates, as a result of the 20.3% mom collapse in growth in April – see “United Kingdom: Back to 1999…and to the Future” (26th June 2020) and Retail Sales Key to UK Economic Growth Recovery (30th July 2020).
Moreover, GDP in the United States outperformed GDP in Mexico, Singapore, the four largest Eurozone economies and most likely the United Kingdom in H1 2020, despite “unfavourable” base effects. Indeed US GDP growth in 2019 (+2.4%) was materially stronger than in Mexico (-0.1%), Italy (+0.3%), Germany (+0.6%), Singapore (+0.7%), the United Kingdom (+1.5%), France (+1.5%) and Spain (+2.0%).
The question now of course is how these major economies will perform in Q3 given that the unwinding of national lockdowns has in some countries (including the United Kingdom) been frozen or even reversed in the face of a rise in the number of local or national covid-19 cases. The outlook for Q4, which for Western countries will mean colder weather and a potential increase in covid-19 related cases, is arguably even more uncertain.
US Dollar has weakened – for good reasons – but is still historically strong
In the same way that markets have seemingly lost perspective about the US economy’s relative performance, markets have made a mountain out of the Dollar’s recent modest depreciation, in our view.
The DXY index, a weighted-average of US Dollar’s exchange rate against the Euro, Sterling, Japanese Yen, Canadian Dollar and Swiss Franc – the other major reserve currencies (along with the Australian Dollar and Chinese Renminbi) – and Swedish Krone, has weakened about 4% since 18th June (see Figure 3). On 3rd August the DXY index was only 0.6% away from the 116-week low recorded on 30th July, according to our estimates. This has led some analysts to argue that the Dollar, which in Q1 accounted for about 62% of the world’s central banks’ allocated FX reserves, is losing its appeal and could eventually cease to be the world’s pre-eminent reserve currency (see Figure 4). We think this is an extreme view with ultimately little basis.
For starters, when the Dollar was appreciating rapidly and global risk appetite collapsing back in March, policy-makers and market participants were ringing alarm bells about the acute imbalance between the strong demand for Dollars and its uneven supply. They warned about the implications for the global financial system and the increased cost to governments, corporates and households of servicing Dollar-denominated debt, particularly in emerging market economies. The Federal Reserve and other major central banks took drastic monetary policy and liquidity measures to redress this imbalance and the Dollar has since been slowly weakening…and yet some analysts are now predicting the demise of the Dollar.
This swing in market perception is excessive, in our view, particularly as the Dollar remains well within its medium-term range. Specifically, we would point out that:
1. The DXY index is currently only about 2.4% weaker than it was on average during 2017-2019 and is about 2.2% stronger than in the previous three year period (2014-2016), according to our estimates (see Figure 3).
2. The Dollar has significantly weakened versus European currencies since 18th June, including about 5% versus the Euro and Sterling, but has only weakened respectively 0.9% and 1.5% versus the Yen and Canadian Dollar (see Figure 5). The Euro accounts for almost 58% of the DXY index and thus its 5% rally against the Dollar has single-handedly accounted for 2.7 percentage points (68%) of the DXY index’s 4% fall.
3. The Dollar Nominal Effective Exchange Rate (NEER), a broader measure of the Dollar against a weighted basket of the currencies of the United States’ major trading partners, has depreciated only 2% since 18th June according to our estimates using latest Federal Reserve trade weights (see Figures 3, 6 & 7). The reason for the NEER’s outperformance versus the DXY index is that the currencies against which the US Dollar has weakened the most in the past six weeks – namely the Euro, Sterling and Swedish Krone – have far smaller weights in the NEER (19%, 5.3% and 0.5%, respectively) than in the DXY index (57.6%, 11.9% and 4.2%).
Indeed the Dollar has weakened by far less against most Latin American currencies (including the Brazilian Real and Mexican Peso) and Asian currencies (including the Yen and Chinese Renminbi) and appreciated against the Thai Baht, Indonesian Rupiah and Russian Rouble. As a result the Euro’s 4.8% appreciation against the Dollar still accounts for 0.9 percentage points (nearly 50%) of the Dollar NEER’s 2% depreciation since 18th June (see Figure 6).
4. The Dollar NEER is still about 5.9% stronger than it was on average during 2017-2019 and 14.7% stronger than in the previous three year period (2014-2016), according to our estimates (see Figures 3 & 7).
Euro appreciation defies apocalyptic forecasts but does not signal permanent shift
The Euro NEER has appreciated about 1.8% since 19th June although it is down 0.4% from the 9-year high recorded on 30th July, according to our estimates using European Central Bank trade weights (see Figure 7).
This move is noteworthy as in the ten years to 1st June 2020 the Euro NEER traded in a range of only 21%, according to our estimates, the narrowest range among 31 major currencies bar the Danish Krone (which is pegged to the Euro), Singapore Dollar (a managed currency) and Romanian Leu (see Figure 8).
In the past two decades there have been countless predictions that the Eurozone would break up (and its 19 constituent states re-adopt their national currencies) or that the Euro would collapse and cease to be one of the world’s preeminent central bank FX reserve currencies. The Euro’s recent appreciation and the steady share of the Euro in the world’s central bank FX reserves around 20% in the past five years (see Figure 4) pour cold water on these doomsday scenarios.
However, the Euro NEER is still within its narrow 10-year range (see Figure 7). Moreover, going forward we think the risk for the Euro at these levels is to the downside, with a less competitive currency likely to weigh on the export competitiveness of open Eurozone economies, including Germany and France.
The bottom line, in our view, is that the Dollar’s depreciation in the past six weeks from a strong level is mainly due to successful central bank policies and a cyclical rotation out of US Dollars into other FX reserve currencies, including the Euro. As a result, the share of Dollars in the world’s central bank FX reserves, which has hovered around 62% in the past two years, may have fallen slightly in recent months (see Figure 4). Conversely, the share of Euros (20%), Sterling (4.4%) and Swiss Franc (0.15%) may have increased marginally.
However, we do not think that FX price action in the past couple of months points to the beginning of a more structural and permanent shift in the currency composition of central banks’ FX reserves. In the same way that apocalyptic forecasts about the Eurozone have failed to materialise, forecasts of the Dollar’s demise as the world’s number one reserve currency are at best extremely premature, at worst unfounded in our view.