#The Tell: 3 reasons why dollar bears shouldn’t throw in the towel

Read: Why the U.S. dollar is soaring — and what’s next — after Fed’s change in tone

To be sure, a more hawkish — or inflation-wary — Fed will limit downside potential for the currency, wrote Zach Pandl, co-head of foreign-exchange strategy at the bank, in a Wednesday note. But he argued that there are three reasons why the dollar still has room to depreciate over the medium and longer term.

Dollar still overvalued

Based on Goldman’s standard models, the dollar is still around 10% overvalued on a trade-weighted basis, Pandl wrote. That’s a legacy of the last business cycle, which left international investors holding a much larger chunk of their assets in U.S. markets.

For example, the share of the external portfolio assets held by euro area investors in U.S. markets rose by 7.5 percentage points to 20.4% in the decade ending in 2020, Pandl said. A similar rise in the share of global mutual fund assets allocated to the U.S. has yet to reverse, while the dollar’s share of global foreign-exchange reserves has slid.

That’s a recipe for dollar weakness if markets outside the U.S. can offer competitive returns over the coming years, something that Pandl sees as a possibility thanks to emerging-market interest rate hikes and strong returns for non-U.S. developed-market equities. The resulting portfolio outflows may weigh on the dollar, he said.

Expectations for Fed tightening go ‘too far’

Last week’s Fed meeting saw policy makers pencil in two rate increases by the end of 2023, earlier than investors had anticipated, while policy makers also began to discuss when it would be appropriate to consider scaling back the central bank’s monthly bond purchases.

Also see: Markets are sending ‘peculiar’ signals as Fed changes tune — here’s what they mean

 The Fed’s heightened sensitive to inflation “has arguably truncated the risk of a sharp dollar depreciation driven by high inflation and very low real rates, and should result in a clearer positive correlation between higher inflation news and USD (U.S. dollar) appreciation,” Pandl acknowledged. Risks for the dollar are “skewed to the upside” over the near term.

Related: Is the reflation trade over? What stock-market investors need to watch

But Goldman continues to look for a weaker dollar versus its developed and emerging market counterparts over the medium term, in part because “market expectations for Fed tightening have likely run too far,” Pandl said.

Goldman economists see just one quarter-point rate increase by the Fed by the end of 2023, while the market has priced in roughly three.

“While the rationale for easier policy can be difficult to see today, it’s important to recognize that most of the factors resulting in rapid growth this year will fade over the next few quarters, with the net impulse to GDP growth turning mildly negative by the middle of next year,” he said.

And while the price level will likely remain higher, the inflation rate — the percent change in price level — should come down significantly, he said, with Goldman looking for core personal-consumption expenditure, or PCE, inflation to fall back below the Fed’s 2% target by May 2022. Slowing growth and inflation should let the Fed remain on hold, he said.

The rest of the world is growing, too

The U.S. economy “is not rebounding in isolation: growth should be very strong in most economies over the next six months as the vaccination process facilitates a global reopening,” Pandl wrote.

In the second half of 2021, Goldman looks for gross domestic product, or GDP, to grow at an annualized rate of 9% in the euro area, 8.5% in Canada, and 6.4% in Japan, alongside 7.7% growth in the U.S. (see charts below).

The continued cyclical rebound means “many other central banks will also need to consider moving away from easy policy over time — indeed, some may be emboldened by the shift from the Fed,” Pandl wrote.

So where’s the dollar headed? The analysts tweaked forecasts to allow for more market sensitivity to incoming inflation news, and now look for the euro
EURUSD,
-0.08%
to trade at $1.20 in three months, $1.23 in six months and $1.25 in 12 months, Pandl wrote, versus previous forecasts for $1.25, $1.27 and $1.28, respectively.