Underpinning the rally in risk assets from the panic lows seen during the worst days of the pandemic lockdowns is a persistently weaker dollar, which is now trading at a discount to fair value for the first time since mid-March.
A lesson re-learned amid that month’s turmoil: when push comes to absolute shove, there is only one real safe-haven — the world’s reserve currency.
As funding costs surged and stress rippled across money markets, investors sold everything that wasn’t tied down to meet margin calls and raise USDs. The fire sale included gold and US Treasurys, with the latter liquidated by foreign accounts, compelling the Fed to establish a foreign repo facility.
Fast forward four months, and the dollar “is looking unloved”, trading at a discount of 1.4% to fair value, Bloomberg’s Ven Ram writes. At the height of the panic, the greenback’s premium was as high as 8%.
The flip side of this story is obviously the euro, which benefited from expectations around the establishment of a landmark €750 billion recovery fund, which became a reality this week after days of intense negotiations.
One key consideration around Europe’s big stride towards a fiscal union is the extent to which it serves as a de-dollarization catalyst. The jointly guaranteed vehicle creates “a massive new pool of high-quality, euro-denominated bonds that could be used by foreign investors to diversify away from Treasurys and the dollar”, Credit Agricole’s Valentin Marinov said earlier this week.
Of course, a stronger euro would serve as a drag on the bloc’s nascent economic recovery. That, in turn, could lead to pushback from the ECB.
“Any discussion of the dollar can’t ignore the euro given the high weighting of the latter in the DXY”, Bloomberg’s Ram said Wednesday. “Given all the weakness in the euro-area economy, it’s unlikely that the ECB will want higher yields or undue euro strength for fear of choking off any signs of inflation”.
In a survey conducted earlier this month, HSBC found that “market participants are leaning towards a weaker USD, but it is far from a convincing majority”.
“Overall, the respondents to our survey were USD bearish”, the bank wrote, adding that,
Just over 46% of the 350+ respondents said they were bearish on the USD in the next 6-12 months. If we remove the fence-sitters, bears outnumber bulls by roughly 2 to1. When the neutrals were forced into a decision whether this the start of a secular bear market, they tended to say no. However, the bears remained steadfast, and a remarkably similar number — around 44% — said that they thought this was the start of a secular USD bear market. This would suggest that the USD bears, are in general, very bearish on the currency and do not think USD weakness will be a flash in the pan.
Respondents said cyclical factors would likely be “the main driver” of USD weakness.
Political issues and the decline of the dollar’s reserve status were “some way back below 30%”, while just 20% of respondents said the US’s twin deficits “would be the key cause of potential USD weakness”, HSBC notes.
I’ve long suggested that the biggest threat to the dollar’s reserve status isn’t the twin deficit concern or the crumbling of the rate differentials pillar (as the Fed moves back to the lower-bound).
Rather, if there’s anything that threatens the dollar’s status as the world’s premier reserve currency, it’s US foreign policy.
For instance, the constant weaponization of the US financial system through draconian sanctions aimed at punishing perceived “foes” (sometimes for not very good reasons) along with the 2018 experience (when the rest of the world was again reminded that financial stability outside the US depends almost entirely on the Fed not erring by over-tightening during a hiking cycle), are likely to be the key drivers of any continued de-dollarization. Not deficits and not “money printing”.
Fiscal unity in Europe could well bolster the common currency as a plausible alternative, and China is pushing for the internationalization of the yuan, although the obstacles are myriad.
Still, as we saw in March, there is no “alternative” to the dollar when things get “real”, so to speak.
As the visual (above) makes clear, this is a glacial process. No matter what happens, the “king” won’t be abdicating the throne anytime soon.
In the meantime, we should all be thankful for dollar weakness. At a time when global trade has collapsed and financial conditions would be prone to tightening in the event major economies are forced back into lockdowns, a weaker dollar is a veritable godsend.