Since the beginning of the year, U.S. 10-year Treasury yields have risen significantly and the U.S. dollar index has bottomed out, triggering turmoil in global financial markets. As the anchor of global asset pricing, the U.S. 10-year Treasury yield almost doubled from a low of 0.9% at the beginning of the year to 1.7%, triggering global stock market adjustments; commodities and housing prices have risen, inflation and capital inflow pressure forced Turkey, Brazil, Russia and other emerging economies to take interest rate hikes in response. The dollar index has climbed from less than 90 to about 92. Will the dollar continue to move upward in 2021, thus creating a reversal of the trend? What challenges will this bring to the financial markets and monetary policies of emerging market countries?
Three reasons for the dollar’s reversal in 2021
Looking back to 2020, the dollar index fell 6.7% for the year, closely related to the strong euro during the same period. The overall effectiveness of Europe’s fight against the epidemic last year was better than that of the U.S., coupled with the EU’s agreement on a $750 billion recovery fund in the middle of the year, and the breakthrough on fiscal synergy boosted market optimism about Europe’s economic recovery, with the euro appreciating against the dollar by 8.9% in 2020. However, since 2021, the U.S. Biden took office after the anti-epidemic measures extremely rapid effect, large-scale stimulus policies to drive the U.S. economic data to improve, inflation expectations climbing pushing up U.S. Treasury yields significantly upward, these three reasons prompted the dollar index rebound, and may also support 2021 dollar sustained strength.
First, the Biden vaccine rollout is leading the way
In contrast to Trump’s negative attitude in response to the epidemic, U.S. President Joe Biden has quickly introduced a series of disease control measures from isolation, masks and medical treatment since he took office, coupled with the large-scale application of vaccines, the U.S. epidemic has been effectively controlled. New cases have been on an overall downward trend since January, with daily new cases in the U.S. between 50,000-60,000 in the last two weeks, much better than the 200,000 or more cases per day in early January. On the other hand, the U.S. leads the world in vaccination, with 100 million doses of the new crown vaccine currently completed in the U.S., accounting for a quarter of the global vaccination volume. Comparatively speaking, vaccination in Europe is slow, while the African region is just starting. The U.S. is expected to take the lead in herd immunization in the second half of this year. Prevention and control go hand in hand with vaccines, and the epidemic has accelerated into a rebound period, supporting the economic recovery and the reversal of the dollar.
Second, large-scale stimulus is driving a strong U.S. economy, and economic expectations are constantly being revised upward
Recently Biden officially signed a $1.9 trillion fiscal bailout plan, pushing the total U.S. fiscal stimulus after the epidemic to $570 million. Biden’s stimulus far exceeded the U.S. output gap, greatly boosting the demand side and supporting a significant rebound in U.S. retail sales. Meanwhile, along with the epidemic under control, the U.S. labor market also picked up significantly, with non-farm payrolls adding 379,000 in February, far exceeding market expectations. In the past year, Europe’s epidemic prevention and control, the smooth launch of the economic stimulus plan is to support the euro rose sharply, but this year, the U.S. economic data and epidemic prevention and control lead, the Federal Reserve and the OECD (OECD) will be the U.S. growth forecast this year raised to 6.5%, much stronger than Europe and Japan.
In addition, after 1.9 trillion stimulus, the Biden administration up to 3 trillion U.S. dollars in infrastructure spending program called for, covering traditional infrastructure, green energy, education, social security and other areas, once the new round of infrastructure landing, will also cause a boost to U.S. investment and the economy. U.S. mainstream investment banks predict that the U.S. economic growth rate this year is much higher than the official forecast of 6.5%, and some institutions even say that the U.S. growth rate this year can be comparable to China.
Third, inflation is expected to climb, the U.S. 10-year Treasury bond yields rose, which constitutes support for the dollar
Since the financial crisis, developed countries’ central banks have taken super-easy monetary policy, including zero interest rates, negative interest rates and quantitative easing, but have never been able to boost core inflation upward, and Treasury yields have been low for a long time. However, the current round of U.S. economic recovery, built on large-scale stimulus to the demand side of the support, core inflation index upward, inflationary pressure increased significantly. For example, the U.S. PCE price index increased 1.5% year-on-year in January, which is close to the pre-epidemic level. Commodity prices, represented by crude oil, are accelerating, and U.S. capital markets and real estate prices are also moving higher. In addition, along with the improvement of the epidemic, the contact service industry is gradually recovering, and structural improvements will push up prices on a larger scale. The U.S. 10-year Treasury yield, the anchor of global asset pricing this year, has quickly moved up from below 1% to 1.75%, and the momentum is still looking up, supporting a stronger dollar.
The negative impact of a stronger dollar and rising inflation on emerging markets
The rise in U.S. Treasury yields and rising inflation expectations have led to a divergence in the pace of monetary policy loosening and tightening across countries this year. Emerging economies are under increased pressure and have to take the lead in raising interest rates, such as the Turkish central bank raising rates by 200 basis points to 19% this month, the Brazilian central bank raising rates by 75 basis points to 2.75% and the Russian central bank raising rates by 25 basis points to 4.5%. Emerging markets are currently plagued by epidemics, and due to their disadvantage in vaccine distribution, low per capita vaccine coverage and vaccination rates, there is a recurring risk of epidemic prevention and control. Forced to raise interest rates will make their economic recovery negative shocks increase, financial market turmoil intensify, making the already fragile economic recovery even more sluggish.
In China, the situation is significantly different. As China takes the lead in controlling the epidemic domestically, it is a global leader in economic recovery, and strong exports have greatly complemented the disruptions in global supply chains, while also contributing to a rise in China’s current account surplus. Given China’s continued open policy to attract foreign investment, China also faces a surplus under direct and portfolio investment, with less net capital outflow pressure than other emerging market countries. At the same time, China’s monetary policy also maintains its conventional, interest rate level is quite higher than that of developed countries. Therefore, the RMB exchange rate will probably still show a slight appreciation this year. However, also of concern are the imported inflationary pressures and the dilemma of balancing monetary policy inside and outside. That is, in the context of the unsynchronized economic recovery and policies in China and the U.S., domestic monetary policy should not only do a good job of considering between risk prevention and stable growth, but also pay more attention to the internal and external balance, encourage two-way capital flows and promote the RMB internationalization process.
To sum up, in 2021, along with the U.S. epidemic inflection point has appeared, large-scale stimulus plan prompted strong economic growth, the U.S. 10-year Treasury yields accelerated upward, the U.S. dollar index may have bottomed out and reversed, and the year is likely to show a consolidation upward trend. And this will also put pressure on emerging market countries, after Turkey, Brazil and Russia have raised interest rates one after another, more and more economies such as India, Malaysia and Thailand are expected to follow. It is not difficult to imagine that in the post-epidemic era, the global economy will have to face an uneven recovery, divergent policies, and increasingly volatile financial markets.