Diversify dollar exposure

We retain our view for further US dollar weakness in 2021. We think that as the recovery gathers pace, driven by the increased availability of COVID-19 vaccine rollouts, more cyclical currencies  should benefit. We expect a corresponding decline in the demand for safe havens, such as the US dollar.

Many investors have built up above-average USD exposure over the past decade as US GDP, bonds, and equities outperformed their G10 counterparts. Even the USD depreciation over the last 12 months did not match the outperformance of US assets versus their global peers.

USD denominated financial assets as a proportion of total global equity and bond market capitalization now stand at their highest level in the last 20 years. This points to the potential for sales of dollar assets as investors seek to stay diversified, or at least hedging of dollar exposures.

The rebound from the COVID-19-induced recession provides an opportunity to consider diversifying away from the greenback. We see further USD depreciation this year - to 1.25 against the euro by year-end in our base case and to 1.30 in our upside case in which economic growth rebounds more sharply. We see several reasons for this weakness:

• The Fed remains extremely expansive; the federal funds target rate is at the zero lower bound and likely to stay there for years to come
• The Fed's balance sheet has grown following the unprecedented effort to soften the economic blow of COVID-19. We do not expect the Fed to start tapering its monthly bond purchases this year.
• US government fiscal stimulus packages are pushing up US debt levels, raising concerns about the sustainability of debt financing.
• Economic recovery favors more pro-cyclical and exporter currencies, not the safe-haven dollar
• Rising vaccine supply will allow a more sustainable reopening of the Eurozone economy and the Eurozone to catch up with the US recovery.
• The US dollar remains overvalued, with purchasing power parity suggesting a fair value for EURUSD of 1.33.

The dollar’s appreciation over the first quarter has now been reversed, but given we expect further weakness, current levels remain attractive to consider unwinding or hedging USD positions.

Looking further ahead, we think the dollar could rebound in 2022. Employment and other US activity indicators are likely to regain values that the Fed would consider persistent enough to reduce asset purchases. Currency markets that try to pre-empt future moves are likely to let the greenback appreciate. The dollar’s appreciation should also come against a backdrop of rising two year yields, which in 2022 should incorporate rate hike expectations for the end of 2023 in the US, and which are an important factor in determining the dollar’s value.

Here are ways that we think USD investors can diversify their currency exposure:

• We expect the US dollar to weaken in 2021.
• We expect the currency to be undermined by the reduction in the US rate advantage, worries over US indebtedness, and a reduction in safe-haven demand for the dollar.
• We see a number of ways to position for this: an equal-weighted G10 currency basket, emerging market and APAC currencies (incl. CNY), and commodity-linked currencies.