The Dollar is On Its Last Legs and they're Beginning to Buckle  

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The Dollar stumbled lower again on Tuesday amid a further improvement of investor risk appetite and is now stood on its last legs that are increasingly being tipped to buckle in the months ahead, leading to a great depreciation that provides the Pound-Dollar rate with a recovery opportunity. 

Investors had sold Dollars for four days on the bounce Tuesday, reducing this year's gain from 6.5% to just 2.7% for the Dollar Index as markets respond to ongoing signs of a flattening epidemic curve in the U.S. and many European countries as well as at the global level. The number of new coronavirus infections declared globally registered its fourth successive decline on Monday, with curves flattening in the U.S, Italy, Spain, France, the UK, Switzerland, the Netherlands and Canada among others. 

Flattening epidemic curves offer investors hope of a restart in the world's major economies as soon as May, with some smaller countries like Austria and the Netherlands already taking steps toward this end. This is a negative for the ultimate safe-haven that is the Dollar now that weakness in the currency has been made possible as well as actively encouraged by the Federal Reserve (Fed), which has taken unprecedented action to reign in the once-runaway U.S. unit while also supporting the economy. 

“Piecing the story together suggests that the Fed’s huge liquidity add (its balance sheet grew to $6.1trn last week, up $270bn on the week) may be starting to ripple its way through the system and that we may be starting to see the emergence of the Risk On, Dollar Off trend that may come to define the rest of 2020,” says Chris Turner, global head of markets at ING. “ We see DXY heading towards 98.25..Temporary monetary financing from the BoE has not hurt the pound, & a soft dollar environment can see Cable test 1.2750.”

Above: Pound-to-Dollar rate shown at daily intervals alongside Dollar Index (black line).

The Fed said Thursday it will provide up to $2.3 trillion in loans to companies and households, an amount equal to more than 10% of U.S. GDP, to "bolster" the effectiveness of the myriad other facilities it's announced this year. This is after Washington legislated for a $2.2 trillion support package that included helicopter money for households as well as uber cheap and yet-still subsidised loans to companies who might otherwise make workers redundant. 

Thursday's announcement came simultaneously alongside the Department of Labor disclosure that another 6 million American jobs were lost to the coronavirus shutdown last week, taking the total to more than 17 million for the last three weeks. Fed policymakers are concerned first and foremost this time around with preserving as many jobs as they can, rather than with short and medium-term inflation outcomes as is normally the case. The bank has a dual mandate that requires it to foster price stability as well as maximum sustainable employment, and Chairman Jerome Powell said last week that consumer price growth is not the foremost concern at present. 

"The ongoing improvement in global investor risk sentiment in the near-term combined with the Fed’s aggressive policy response is beginning to weigh down more on the US dollar. The size of the Fed’s balance sheet had already jumped to just over USD6 trillion in the week ending the 8 th April, and is set to continue its unprecedented pace of expansion in the coming months after the Fed’s announcement of a another package of support measures totalling up to USD2.3 trillion," says Lee Hardman, a currency analyst at MUFG. "Despite the recent slowdown in the pace of QE, we still believe the Fed’s aggressive policy response poses downside risks for the US dollar."

Above: Dollar Index shown at weekly intervals.

The Dollar Index, which measures the greenback against a basket of Euros, Pounds, Japanese Yen, Swiss Francs, Swedish Krona and Canadian Dollars, had risen 8.5% from trough to peak between March 06 and March 20 as investors dumped risky and supposed safe assets alike in part of a great dash for cash that was so sudden and significant in the making that the relevant currency moves were themselves posing a threat to the global economy. 

Since early March the Fed has announced two dozen or more different actions including an unlimited quantitative easing program and a more-than doubling of the number of other central banks who have Dollar swap lines with it. New swap lines provide up to $60bn of cheap Dollars through off-market transactions that can be used to ease liquidity shortages in foreign jurisdictions and as a result, reduce overall market demand for the greenback.  

The latest measures will involve the Fed directly in the primary market for some corporate bonds as well as the secondary market for others. It will also buy shares of exchange-traded-funds that invest themselves in low rated corporate debt. The bank is leaving nobody behind but risks controversy on some parts of the ideological spectrum by entering the 'junk' bond market where the debts of companies with less-than-perfect credit scores trade. 

Above: Nordea Markets graph illustrates EUR/USD relationship with changes in relative size of ECB and Fed balance sheets.

"The US Treasury is now officially the credit risk owner of last resort for the entire economy with the Fed's backing," says Andreas Steno Larsen, a strategist at Nordea Markets. "The Fed’s print-a-rama will likely outpace that of peers by miles this year. The ECBs QE-ternity and PEPP-programs will add a tad more than EUR 1trn over the coming 9 months (10% of EA GDP), while the Fed will likely add USD 3trn just via the SOMA-purchases before year-end (the balance sheet will explode for other reasons as well), which will account for almost 15% of GDP. Good thing that the USD-printing is now electronic, otherwise the Fed could have run into environmental issues." 

Larsen says the Fed has pumped enough liquidity - or Dollars - into the finanial system to mean the market will be radically oversupplied with the U.S. currency as and when trading and economic conditions begin to normalise.

He and the Nordea team told clients this week and last that such an oversupply is a significant downside risk that might be worth as much as 15 percentage points to the Dollar over the next 24 months or so. 

Above: Euro-to-Dollar rate shown at daily intervals alongside Dollar Index (black line).

Crucially, and as it relates to the Dollar Index, the Euro-to-Dollar rate could be among the most notable beneficiaries if and when the relative size of central bank balance sheets begins to matter again to investors.

Euro-to-Dollar rate transactions account for more than half of the flows measured by the Dollar Index so when the Euro rises it can often be enough to tip the broader measure of the greenback lower on its own.

The Fed's litany of economic and financial support schemes announced last week are expected to add at least $3 trillion new Dollars to the market, worth around 15% of U.S. GDP, whereas all of the new Euros created by the European Central Bank (ECB) are seen totting up to only around €1 trillion or 10% of GDP. Larsen says the actual number of new Dollars that hits the market will be even larger than $3 trillion by the time that all is said and done. 

"The big dollar is down for the count at the moment, but the patterns in recent trading suggest that it is merely the flipside of global risk sentiment and the technical reversal of the prior USD rally is not yet profound enough to say that we have reversed course. The euro [is] not terribly impressed with the Eurogroup’s agreed rescue package as the single currency is notably lower versus CHF and JPY despite a risk on tone – looking vulnerable even against GBP," says John Hardy, head of FX strategy at Saxo Bank. "Sterling [is giving] an impressive show of strength – some springback possibly from Boris Johnson emerging from his personal Covid19 crisis, but also the weak euro weighing as well as the UK’s easier path to stimulus on all fronts. Next test would be how the pound performs broadly if risk sentiment sours."