Slumping U.S. Dollar Creates Problem for Central Banks Elsewhere

The euro and yen are flirting with valuations unseen for years as dollar weakness creates headaches for policy makers the world over.

Granted, the path higher may be rocky, as seen with the greenback paring its decline Wednesday morning in New York on haven demand after the New York Stock Exchange reversed course and said it still plans to delist three major Chinese companies.

But strategists say Europe’s shared currency is heading toward $1.25, a level it hasn’t traded above consistently in over six years, with the European Central Bank proving willing to verbally bat down forays higher. The yen, meanwhile, is already drawing the attention of Japanese officials after it hit a nine-month high, and traders may yet target its strongest since 2016.

The moves are testament to the sweeping influence of the dollar, whose descent has already driven China’s yuan past a key threshold, to the discomfort of policymakers there.

Slumping U.S. Dollar Creates Problem for Central Banks Elsewhere

“I believe $1.25 could be the ECB’s ‘line in the sand’ as the euro would be entering into overvalued territory if it breaks above that level on a sustained basis, thus hurting the euro zone’s international competitiveness,” said Valentin Marinov, head of G-10 foreign-exchange research at Credit Agricole. “The verbal intervention could start again in earnest below that level, especially if the euro zone inflation continues to disappoint even the ECB’s downbeat projections.”

During the panic in March as the pandemic shuttered the global economy, the dollar’s strength was the problem for central bankers. But since then the narrative for the greenback has turned to weakness.

A Bloomberg gauge of the dollar touched as low as about 1112 on Wednesday, the weakest since February 2018, as investors bet on a global vaccine-fueled recovery that will reflate the world economy and lure money from the U.S. Traders are also wagering that a unified Democratic government is likely to boost U.S. stimulus measures. The party was poised to take control of the Senate with the Georgia runoff races winding down.

While the U.S. 10-year Treasury yield just eclipsed 1% for the first time since March, the key for some strategists is real yields, which strip out inflation and have tumbled to record lows amid the revived reflation trade.

“For me the big three levels to watch are going to be 1.25 in EUR/USD, 1110 in the Bloomberg Dollar Index and 6.20 in USD/CNH,” said Brad Bechtel, global head of foreign exchange at Jefferies, who sees all of those levels being surpassed in the coming weeks. “Then the question will become: Are we going to have this much inflation and if not, is the U.S. dollar valued correctly at current levels?”

The dollar last traded at $1.23 per euro, 103.25 yen and about 6.45 yuan.

The 10-year real yield, at minus 1.05%, suggests the market has confidence in the reflation story, spurred in party by ultraloose Fed policy.

“U.S. real yields are going to be low intentionally with the blessing of both Treasury and Fed,” said Steven Englander, head of global G-10 FX research at Standard Chartered Bank. “Dollar weakness is still the trade.”

That depreciation is a concern for global policymakers, who face their local currencies becoming too expensive relative to that of the world’s largest economy, jeopardizing exports.

In Europe, the ECB showed as recently as last year that it’s willing to take a stand if the euro’s rally is seen to hinder its broader policy goals. Its brief September foray above $1.20 was cut short by ECB member Philip Lane’s comment that the euro’s level “does matter” for monetary policy.

When the euro tested $1.20 again late last year, the fear arose again that ECB officials might talk down the rally. Yet broad-based dollar weakness ultimately drove the shared currency higher, leaving analysts to conclude that as long as the yen and euro’s gains are gradual and part of a broad trend, their appreciation may persist.

©2021 Bloomberg L.P.

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