Why Is the Dollar currently Oversold?

One of the greatest consequences in financial markets is that the U.S. dollar will weaken. It has weakened during the course of 2020, and it will weaken moving forward. The arguments in favor are more than compelling – the United States is the country with the most aggressive monetary and fiscal accommodation in the world.

If we look at the fiscal package, the U.S. stimulus comes close to $3 trillion – $900 billion from last December, which will make its way into the economy in 2021 and another $1.9 trillion expected to be delivered by the Biden’s administration by the end of this month.

Yet, some caution is required. Yes, the fiscal stimulus, much-needed, weighs on the dollar’s strength, but a comparison with what happens in other parts of the world tells the cautious investor at least to rethink the thesis of a lower dollar.

Sharp Economic Recovery to Bode Well for the Greenback

Dollar bulls, as few as there may be out there, have three arguments for the comeback of the greenback. One is the central banks’ balance sheet.

The picture above reflects an incredible, yet simple, aspect – the Fed’s balance sheet is not the most “expanded” in the world, as many would have thought. After the Great Financial Crisis of 2008-2009 and the introduction of the Quantitative Easing (QE), the central banks’ balance sheets are the ones to look at in order to estimate the accommodative conditions in an economy.

How best to do so if not to compare the balance sheet with the economy’s size? Therefore, the central bank’s balance sheet as a percentage of the Gross Domestic Product (GDP) is a key metric in understanding the effect of the QE on various economies and, thus, to apply the outcome when looking for fundamental trades in the FX market.

The Fed is NOT the central bank with the most accommodating conditions. The Bank of Japan, the European Central Bank, the Bank of England – they all have a larger balance sheet expansion when measured as a percentage of the GDP.

Second, the vaccination rate. The U.S. leads the world with two-point-something million people getting the jab every single day. At this pace, which is prone to increase, the herd immunity is just around the corner (read the end of the summer) – which leads us to the third argument.

More fiscal stimulus coupled with a rising pace of vaccinations will lead to faster economic recovery and, why not, more growth even when compared to pre-pandemic levels. Effectively, it means that the balance sheet at the Fed will shrink, rather than expand, as the economy grows faster than competitors while the QE is still measured as a percentage of the GDP.

Dollar bears may enjoy the current environment, but the conditions may not last for long – the quicker the U.S. economy rebounds, the less impressive the Fed’s QE will be.