Investors should be concerned about the value of the dollar, but a portion of the current dynamics are normal. In the short-run, a crisis will create a run on safe assets which will push the dollar higher as investors move to Treasuries and avoid risky assets. Once this liquidity crisis subsides, the excess dollar demand will reverse. The reversal will usually be more pronounced with advanced economies than with emerging currencies given the higher EM risks. We have seen this liquidity stress process work through current financial markets. Dollar swaps with the Fed are no longer necessary to provide liquidity. Beyond the liquidity crisis, the relative macroeconomics will rule dollar moves.
Regardless of the liquidity crisis effect, the dollar is likely to continue to weaken as long as Fed monetary policy is relatively easy versus other major central banks. The favorable dollar interest differential especially versus advance economies has collapsed. While a monetary approach to exchange rates may be a poor forecast in the short-run, the current size of Fed balance sheet expansion is a blunt signal for currency markets.
Given that many goods and services are priced in dollar, the current decline will support higher product demand. The dollar is still above post-GFC levels, so a gradual decline may mot be threatening to global financial health. Additionally, the dollar decline is euro focused and has not been seen in emerging markets.
Concerns about the dollar also have to be tempered or measured through which lens is being used to discuss currencies. We will note that the dollar-euro exchange rate does not represent the dynamics of the dollar in general. The Fed dollar indices are traded-weighted not capital flow weighted. We have provided the weights for the advanced and emerging Fed dollar index. We will note that the Fed advanced economies dollar index will differ from the ICE DXY futures-based dollar which has an over 55% euro weight. It matters which dollar you are discussing. Watch but don't panic.
Regardless of the liquidity crisis effect, the dollar is likely to continue to weaken as long as Fed monetary policy is relatively easy versus other major central banks. The favorable dollar interest differential especially versus advance economies has collapsed. While a monetary approach to exchange rates may be a poor forecast in the short-run, the current size of Fed balance sheet expansion is a blunt signal for currency markets.
Given that many goods and services are priced in dollar, the current decline will support higher product demand. The dollar is still above post-GFC levels, so a gradual decline may mot be threatening to global financial health. Additionally, the dollar decline is euro focused and has not been seen in emerging markets.
Concerns about the dollar also have to be tempered or measured through which lens is being used to discuss currencies. We will note that the dollar-euro exchange rate does not represent the dynamics of the dollar in general. The Fed dollar indices are traded-weighted not capital flow weighted. We have provided the weights for the advanced and emerging Fed dollar index. We will note that the Fed advanced economies dollar index will differ from the ICE DXY futures-based dollar which has an over 55% euro weight. It matters which dollar you are discussing. Watch but don't panic.
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