The investment world has seen no bigger widow-maker trade this last decade than shorting the US dollar. Yet recent volatility in the reserve currency has punters once again asking whether the great dollar reckoning is finally afoot?
No one knows, of course. The dollar’s sudden and sharp drop in recent days, though, has the whiff of exactly the sort of foreign-exchange shock for which markets have been bracing. As investors wait to see if things unravel, finally, it’s worth exploring how bad things might get.
For now, the dollar’s stumble can easily be explained by shifting considerations of interest rate differential expectations. As strategist Steven Barrow at Standard Bank puts it: “Our call for the dollar to enter a multi-year downtrend is partly based on the fact that the Fed’s tightening cycle will morph into an easing cycle, and this will pull the dollar down even as other central banks cut as well.”
News that inflation rose just 3% in June year on year, a third of the rate of increase a year before, suggests that the most aggressive Federal Reserve tightening cycle in three decades is winding down. The Bank of Japan, by comparison, is locked in place policy-wise, while the People’s Bank of China is in rate-cut mode.
Yet currency crises tend to come very suddenly. It doesn’t take much for a stumble to morph into the real thing. Once a critical mass of global investors starts taking a serious look at the dollar’s fundamentals, things could go south at warp speed.
Chief among the negative data points: a fast-widening current-account deficit; a national debt topping US$32 trillion; highly indebted households, buckling under the weight of hundreds of basis points worth of higher borrowing costs; President Joe Biden’s move to weaponize the dollar to punish Russia over Ukraine; trade friction with China; and a level of political bickering in Washington that has Fitch Ratings mulling a downgrade.
“There’s little evidence, however, of a sustainable uptrend in dollars at this point,” says J C Parets, founder and president of advisory AllStarCharts.com. “In fact, the majority of the data continues to point towards a lower US dollar.”
Strategist Masafumi Yamamoto at Mizuho Securities thinks the dollar will remain “under pressure” unless new evidence emerges that the US economy is “outperforming other countries.”
Economist Edward Bell at Emirates NBD says indications are that “the dollar’s prime position appears largely unchallenged, thus far. But there are developments that may yet drive a longer-term shift away from the US dollar, including the use of sanctions as a US foreign policy tool. There has also been a rise in bilateral agreements to settle trade in local currencies rather than the US dollar.”
A key problem, of course, is a lack of ready alternatives. Analysts at Fitch Analytics argue that “while the US dollar’s role will continue to decline over the coming years, it will be a slow erosion, rather than a paradigm shift. Most importantly, there is no real alternative to the US dollar, and the Chinese yuan is unlikely to become one in the near future.”
Bell adds that “despite a potential longer-term desire amongst some economies to diversify away from the dollar, there are also some fundamental stumbling blocks that may slow or limit this process.” As the International Monetary Fund has suggested, Bell notes, “there is significant inertia in reserve currency status, with a strong bias to using whichever reserve currency has been dominant in the most recent past.”
One possible reason for this inertia, Bell says, “may be the US dollar’s safe-haven status, evident in the perennial demand for US government bonds, even during times when there is heightened risk within the US economy itself. There is also a lack of feasible alternatives, with both the euro and the yuan facing their own issues as real challengers to the dollar.”
Yet little of this will matter if fundamentals get away from Washington. In 1971, Nixon-era Treasury Secretary John Connally famously said that the “dollar is our currency, but it’s your problem.” Fifty-two years later, Asia is on the frontlines of this very phenomenon.
The dollar has peaked both in cyclical and secular terms,” says strategist Luca Paolini at Pictet Asset Management. “The overvaluation is significant and our models show the dollar is 20% above its fair value versus a basket of currencies. US productivity growth is weak, fiscal policy is too loose and interest rate differentials are no longer supportive of the US currency. The dollar’s depreciation is likely to be particularly pronounced against low-yielding currencies, such as the Swiss franc.”
The risk is that investors turn on the dollar en masse, setting off a disastrous domino effect. It’s then that the poor financial fundamentals unnerving markets collide with geopolitical tensions. A big one is governments from China to Russia to Saudi Arabia searching for alternatives.
The ways in which the Biden White House moved in 2022 to freeze some of Russia’s currency reserves only encouraged the anti-dollar movement.
In April, US Treasury Secretary Janet Yellen acknowledged that “There is risk when we use financial sanctions that are linked to the role of the dollar that over time it could undermine the hegemony of the dollar.” Yet, she added, the dollar “is used as a global currency for reasons” that include the fact it is “not easy for other countries to find an alternative with the same properties.”
Julius Sen, a political economy expert at the London School of Economics, notes that the term weaponization is “apt as it explains how a relatively neutral but essential facility – the dollar and its accompanying payment system – have been turned into a powerful weapon by one UN member state against another without appropriate sanctions in place.” In addition to amounting to weaponization, the freeze on Russian currency reserves “also represents an aggressive form of extraterritoriality which has perhaps not been seen on this scale in the past.”
Washington’s use of the dollar to gain political leverage could drive other countries to “find their own coping mechanisms,” Sen says. Possible mechanisms that he lists include diversifying into other currencies, shunning dollar-denominated assets and turning to capital controls.
For China’s yuan, the lack of full convertibility remains a turnoff for many global investors. And, in the short run, so is concern that Asia’s biggest economy is veering toward deflation.
Analyst Kelvin Wong at OANDA warns that “further yuan weakness is likely to put more financial burden on the current offshore bonds payment obligations of Chinese property developers where the property industry still faces a credit crunch issue due to a weak internal demand environment.”
What’s more, Wong adds, “brewing financial stress of major Chinese property developers is on the rise again: Prices of their onshore dollar bonds tumbled significantly in the last two days.”
Adding to the PBOC’s list of worries, Wong says, are a trading halt announcement made by Sino-Ocean Group in a local note that is due to mature in two weeks and Dalian Wanda Group’s issuance of a warning to its creditors of a funding shortfall for a bond that is due for redemption on July 23.
The bottom line, Wong says, is that “failure to negate the current negative sentiment in the China stock market may further reinforce a negative feedback loop into the real economy which in turn increases the risk of a deflationary spiral.”
Yet the dollar’s downward trajectory could have the yuan moving higher in the second half of 2023. Strategist Kit Juckes at Société Générale thinks the dollar could soon return to its December 2020 lows.
“As was the case in January/February before the SVB mini crisis, the market is anticipating the peak in US rates and a further narrowing relative rates,” Juckes notes. “If nothing happens to scupper those expectations — another upside surprise in US growth, or further European growth disappointment — I would expect the Dollar Index to move closer but not all the way to the lows at the end of 2020.”
After that, no one really knows. The typical financial dynamics and yardsticks are far less applicable in today’s market environment.
“We’ve got a one-in-a-100-years pandemic and a once-in-75-years war and a-once-in-25-years energy crisis all thrown into the mix together,” Juckes explains. “You’ve got to be 120 years old to have any understanding of this.”
One such imponderable today is how central banks and governments tame inflation emanating from non-monetary sources — including from supply chain tensions beyond policymakers’ control.
“The great lingering fear among central banks is that the longer it takes to bring down inflation, the greater the risk of it becoming entrenched,” says economist David Bassanese at BetaShares Exchange Traded Funds.
That’s why, notes George Saravelos, global head of FX research at Deutsche Bank, “a confirmation that the US disinflation process is underway in soft landing conditions is for us the most important macro variable for the rest of the year.”
Yet no risk trumps that of the dollar, the linchpin of international finance, finally having its comeuppance. It’s too early to say that this long-awaited reckoning is afoot. If it is, economies everywhere will quickly find themselves in harm’s way.