The dollar was on track for a weekly gain Friday, as the greenback rose in conjunction with upbeat data on the US housing market and the juxtaposition between better-than-expected PMIs stateside and more subdued readings across the pond.
The “dollar demise” story captured the market’s attention over the summer. America’s struggle with the coronavirus and deeply negative real rates undercut the greenback, while the political dysfunction on full display in D.C. marked a stark contrast with the establishment of the European recovery fund.
With bullish bets stretched in the common currency, and positioning net bearish on the dollar for the first time in years, many now believe the euro is due for a breather.
Read more: Heavy Is The Head
“It is time to take profit and turn more cautious on EUR/USD”, Deutsche Bank’s George Saravelos wrote Thursday, for example.
Saravelos has been a EUR/USD bull since 1.10, and he makes it clear that Deutsche is “not turning dollar bulls nor are we arguing for a big reversal back down”. Rather, he says the “risks are more evenly balanced” now, and consolidation is the “most likely outcome”.
SocGen’s Kit Juckes has voiced similar sentiments of late.
And then there’s Scotiabank’s Shaun Osborne who, on Friday, wrote that even as the “broader backdrop for the USD [remains] challenging, the window may be opening for some stabilization or moderation in the broader dollar decline”, especially headed into into next week’s virtual Jackson Hole confab. We saw on Wednesday how little it takes to turn the tide when the market’s read on the July FOMC minutes triggered a knee-jerk surge in the greenback.
But beyond near-term tactical concerns, the more interesting discussion is around the dollar’s longer-term prospects and, relatedly, its future as the world’s reserve currency. I’ve obviously spilled gallons of digital ink expounding on these issues over the course of this summer’s dollar doldrums (see here and here), but Deutsche’s Saravelos offers some incremental color worth mentioning.
For his part, Saravelos doesn’t think concerns about the dollar’s reserve currency status or worries about inflation are behind the bear case. He notes, for example, that “it would take an active and extremely large reallocation away from USD reserves to weaken the dollar”.
Instead, as the figure shows, custody holdings at the Fed have recouped the decline seen during the panic when the world was liquidating Treasurys to (ironically) raise USDs. Custody holdings, Saravelos notes, “would be the first to decrease assuming greater fear of reserve appropriation risk from the US”.
As for price pressures, he writes that “there is no idiosyncratic inflation risk premium being added to the greenback”.
So, what’s behind the bear case? For Saravelos there are two drivers, the widening US current account deficit “and an unwind of the private-sector dollar overweight both in terms of asset allocation as well as extremely low hedge ratios”, he says, adding that,
It is hard to obtain real-time data on both but our structural view is that this dynamic has more [room] to run. The share of dollar equity assets in European holdings is close to record highs according to the ECB securities statistics database. A shift here accompanied by a widening current account deficit would be the clearest [sign] of a bigger shift in the US basic balance, which has historically been the fundamental driver of dollar trends.
It sounds as though this particular bear case may take some time to pan out. For instance, as noted here on Monday, foreigners were buyers of US equities again in June, after a record splurge in May.
As for the reserve currency debate, Saravelos strikes a similar tone to that I’ve adopted recently when discussing the dollar’s recent trials and tribulations in the face of domestic political dysfunction.
“We would not hang our hat on a US reserve story ahead of a historic US election”, he writes, adding that “a Biden victory would likely cement, rather than reverse, the dollar’s reserve status”.
Hedge funds apparently don’t agree. “Not only are they betting the [euro’s] rally will continue, they see it rising to a level last seen in early 2018”, Bloomberg’s Vassilis Karamanis wrote Thursday. “The chances of a Democratic win, and what that means to US fiscal plans, are among the main drivers of the dollar’s weakness”, according to traders who spoke off the record.