Coronavirus Darkens Dollar Outlook

March 7, 2020

After simmering on low for two months, the Covid-19 outbreak slammed world financial markets to create back-to-back weekly volatility on a scale with few precedents over the past four decades. Stocks, long-term interest rates, commodity prices and foreign exchange were all sucked into the maelstrom.

  • The DOW closed February 21st down just 0.4% over the prior two weeks. By February 27th, it was 12.4% lower than two weeks earlier, and it also posted a double-digit two-week drop in four of the ensuing six business days.
  • The 10-year U.S. Treasury yield dropped 73 basis points in the past two weeks and 118 basis points since end-2019 to an alltime low of 0.74%. The 30-year Treasury cratered 42 basis points on the final two days of last week.
  • The price of West Texas Intermediate crude oil dropped 22.7% over the last two weeks.
  • In this span, too, the dollar depreciated 4.5% against the euro and 5.8% versus the yen.

Bursts of similarly very steep declines in the DJIA occurred in early September 1998, late-September 2001, and October 2008. Like the past two weeks, each of these earlier episodes was associated with a shock to the system: the failure of Long-term Capital Management, the Al Quada attacks in the United States, and the intensifying Great Recession after Lehman Brothers went bankrupt. Not all of these incidents saw the dollar decline, however. Dollar/yen ended 2001 almost 9% stronger than its level just prior to the 9-11 attacks, and the U.S. currency’s net change versus the euro in the span was trivial. From October 8, 2008 until March 5, 2009, the dollar climbed 8.8% against the euro, while edging just 0.5% lower against the yen.

So what is it about some shocks that make the dollar more vulnerable than others? A shock in the past when the dollar fell widely occurred  right after the first OPEC oil price shock. Supply shortages in the autumn of 1973 were followed in early 1974 by a quadrupling in the price of oil. This shock accelerated inflation, elicited a tightening of Fed policy and was associated with a long recession that didn’t end until near the end of the first quarter of 1975. More recently when U.S. equities tumbled between the failure of Lehman Brothers on September 12, 2008 and when share prices hit bottom early the following March, the dollar fell 8.6% against the yen but rose 10.8% against the euro.

One other instance when the dollar fell against both the yen (7.7%) and key European currencies like the mark (4.6%) was in the first half of September 1998 when the failure of a highly interconnected hedge fund Long-Term Capital Management caused many market players to fear a recession, which as it turned out did not ensue in coming months. The dot-com recession didn’t begin for another year and a half, and that downturn was both mild and brief. In fact, by the time of the 9-11 attacks, that recession was starting to peter out.

The key to the dollar’s fate over the balance of 2020, it would seem, is whether current concerns that the Coronavirus will trigger a recession soon prove correct. At the end of 2019, few analysts perceived the possibility of a U.S. recession in 2020 as very large. Now the odds seem almost even. One risk is the record longevity of the current U.S. economic upswing, but the trio of well-timed Federal Reserve policy easings last year should help. The still-evolving Coronavirus is shrouded in great and many uncertainties of a scientific and political nature. In the end, the economic impact to the United States is likely to dominate the dollar’s response. Data coming in from China suggest a very pronounced economic hit there, so investors will initially take their cue from the epidemiological path the disease takes in the United States. President Trump’s obsession with the U.S. trade deficit and the lower-than-desired starting point in U.S. inflation suggest that little policy resistance to additional dollar depreciation will be offered by his administration.

However, investors will need to be on guard against policy surprises like the timing and size of last week’s Federal Reserve interest rate cut. The most dramatic gesture conceivably would be an elimination of all tariffs on Chinese imports. It needn’t be a permanent move but just framed as a gesture in good faith and mutual opportunity to help the Chinese economy get back on its feet quickly. This would restore ruptured supply chains more quickly, benefiting U.S. companies.

A final thought is that one should not assume that with 2020 being a presidential election year, the government will do whatever it takes to maintain decently positive growth through the early autumn. With a crisis like a global health pandemic, governments have limited means to avert economic contractions while the shock is playing out. The Great Recession struck in an election year, too.

Copyright 2020, Larry Greenberg. All rights reserved. No secondary distribution without express permission.



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