The US Dollar has exhibited a strong weakening trend since March, causing analysts to speculate whether the dominance of the Greenback could be threatened over the coming year. Looking at the US Dollar Index (DXY) the currency has slumped from over 102 towards the end of March to a rate of 93 today – an almost 9 percent plunge in less than six months.

According to a Reuters poll of currency forecasters USD weakness is set to persist into 2021, with around half saying it is overvalued and likely to lose out to other major developed market currencies, including the Euro. More broadly, the Dollar recently hit 2018 lows against a number of its rivals, although it has clawed back some of its losses against the Pound in the last week due to heightened Brexit anxiety.

What factors caused this slide in the Dollar’s value, and is this trend set to continue? Below we outline some of the main drivers.

CORONAVIRUS IMPACT AND ITS EFFECT ON DOLLAR DOMINANCE

The weakening Dollar trend corresponds neatly with the near shutting down of economic activity across the globe to combat the spread of the Covid-19 virus. The safe haven status usually associated with the US currency has taken a battering due to a multiplicity of factors, the main one being cratering international trade levels and the associated impact on commodities. Lower overall demand led to lower demand for USD.

Once the main danger of the Covid-19 virus had passed and national economies began to reopen, the upsurge in risk appetite has only served to hasten the downside pressure on USD in favour of commodity linked currencies such as the Australian Dollar. Indeed, AUD/USD has made steady gains, rising from US$0.58 in March to US$0.74 by the start of September.

However, as case number of the virus continue to rise in the United States, the potential for any USD recovery remains limited as long as its economic impacts remain unknown.

US POLITICAL UNCERTAINTY KEEPS A CAP ON THE DOLLAR

This November’s US presidential election is another driver of uncertainty that is limiting USD appeal. Currency market positioning indicates investors are unwilling to increase their USD positions ahead of what is shaping up to be one of the most hotly contested elections in recent US history. Dollar short positions are at their highest level since 2011.

Forex markets remain somewhat ambivalent about the outcome of the election, although a majority of analysts expect USD to rise if incumbent Donald Trump wins a second term. Mr Trump has indicated that interest rates could rise if he remains in the Oval Office.

Meanwhile, political tensions have spilled over onto the streets of America, with many cities experiencing demonstrations and rioting in recent weeks. All this adds to the uncertainty hanging over the United States at present, further tainting USD with an intangible sense of risk.

ECONOMIC FACTORS AND THE FEDERAL RESERVE

At the same time, the recovery of the US economy from its pandemic lows remains shaky. Having contracted at an annualised rate of 32.9 percent during the second quarter, the US economy has a lot of ground to make up before any recovery can truly be said to be sustainable. The official rate of unemployment continues to decline and US stock markets continue to probe all-time highs, but until domestic demand picks up again markets are wary of putting too much faith in the US economy.

The Federal Reserve responded to the devastating effects of the Covid-19 trade and travel lockdown with huge amounts of stimulus in the form of more than $3 trillion in loans and asset purchases, as well as there being direct support for individuals and businesses. With interest rates already lowered to just above zero, and little prospect of them rising again for the foreseeable future, markets saw little reason to buy USD.

However, it was the recent announcement by Fed Chair Jerome Powell that the central bank will be changing its decades-old inflation policy that further rattled markets. Despite a brief blip higher for USD, the news that inflation will be left to run above 2 percent sent a message that the Fed was resorting to more draconian measures to help the ailing US economy.

GLOBAL FACTORS CONTRIBUTE TO BEARISH USD

While domestic concerns have played a part in the weakening of the Dollar over the past six months, the global dimension cannot be overlooked. In this regard the Dollar’s main rival, the Euro, has outperformed it. The EU’s response to rebuilding its economy after the lockdown was deemed to have been a success, although recent data and infection rates indicate this may have plateaued.

At the same time, the aforementioned risk-on move has only hindered the ability of the US Dollar to regain lost ground, especially as China has ramped up production once again and concerted global central bank action has curtailed risk.

USD OUTLOOK RIDES ON ECONOMIC DATA, FED POLICY AND VOTING INTENTIONS

While the longer-term outlook for the Dollar remains uncertain, the factors that have caused the sustained weakening trend shows no signs of reversing in the near term. Although USD may gain some traction if Eurozone data continues to weaken, it is likely to be held back by the political uncertainty surrounding the upcoming election.

With fears rampant that a second wave of the Covid-19 virus will impact economic activity over the winter, we will find out if USD has hit a bottom and whether it will rise again in line with risk-off sentiment. In the meantime, however, with USD showing a promising start to the third quarter, a lot will depend on whether looser monetary and fiscal policy is on the way, and to what extent any new economic data releases impact voting intentions ahead of the election.

For the time being, Dollar value remains a vote of confidence in the US itself, something that should become clearer as we head into the final quarter of 2020.