What next for the US dollar?
The sudden and sharp deterioration of economic and financial conditions caused by the global outbreak of the Covid-19 pandemic has led to an unprecedented spike in demand for US dollars in recent weeks. This is largely in order for various entities to meet liabilities. As a result, we have seen a sharp rise in the cost of US dollar funding.
What’s behind this sharp rise in demand for US dollars and why is it a problem?
Well-functioning funding markets are essential for the global economy. The majority of global trade, commodities and debt issuance (particularly across emerging market economies) is priced in US dollars.
As such, having access to US dollar funding at reasonable levels is essential for all global financial institutions and corporates in order for their operations to function smoothly. US dollar funding stress caused by an extreme increase in demand for US dollars, can also increase hedging costs for foreign investors investing in dollar assets.
What could bring an end to dollar hoarding by companies and investors?
Firstly, we would need to see some stability in funding markets. Access to appropriately-priced US dollars in both spot and forward markets would be the first sign that some equilibrium is returning to funding markets. This is most readily seen by looking at the US currency on a forward basis i.e. whether the forward market is in line with interest rate differentials between different currencies.
Another way to assess this is to monitor the FRA-OIS spread, as shown below. This gives us an indication of the future borrowing costs for banks as it shows the difference between LIBOR (the inter-bank lending rate) and the risk-free interest rate set by central banks. The spread between the two has widened hugely (showing that borrowing costs have risen).
This would be most easily addressed by the US Federal Reserve (Fed) essentially flooding the markets with US dollars through quantitative easing (QE) and repurchase operations. Significantly enlarged swap lines have now been put in place with other central banks to help alleviate the demand for US dollars.
The second element that would help reduce US dollar hoarding is ensuring that credit is available. As mentioned above, most international trade is priced in US dollars, as such, trade finance is the lifeblood of an orderly market.
Many corporates will draw upon existing credit lines that they have already arranged with banks. However, the extreme circumstances surrounding the Covid-19 threat has meant that credit markets overall are struggling to find the required credit, but also credit at a reasonable price.
Clearly, central bank intervention in the corporate bond market helps as do the emergency credit facilities which governments have put in place for small and mid-sized companies which cannot access the corporate bond market. A decline in credit spreads but also in volatility will be taken as signs that governments and central banks are winning this particular battle.
Finally, some visibility that there is an end to the crisis would be helpful, particularly if investors and businesses were able to see light at the end of the tunnel and that growth was set to return. This would mean sales could restart and money start to come in again.
At this point, companies will be able to start investing, people will be re-employed and spending will resume, thereby removing the need to hoard cash and the US dollar. However, given that markets are inherently forward looking, waiting for clear signs that growth is on the mend could mean missing out on a significant retracement in the meteoric rise in the US dollar.
Will the US dollar decline from here?
For the outlook for the US dollar, we see two elements which could cause a decline from here. Firstly, once the shortage of US dollars is alleviated by the activities of central banks and governments and funding stresses abate, it is likely that the US dollar will retrace a good portion of its recent gains.
Secondly, before Covid-19 arrived, the US dollar was increasingly expensive. Investors had already loaded up on the greenback because it offered the advantage of higher yields and the US was growing more strongly than the rest of the world.
Clearly, the Fed’s actions in reducing US rates to essentially zero – and also restarting the most aggressive of all central banks' QE programmes, to truly do whatever it takes - will remove some of the interest rate advantage investors had been drawn to.
For the growth outlook, the US economy is also at a disadvantage. The flexibility of its labour markets and service sector-heavy economy are likely to put it at a distinct disadvantage to other regions including Europe and parts of Asia.
In short, it is a lot easier to make workers redundant in the US, and we have already seen an eye-watering rise in unemployment, while various parts of the services sector (tourism, travel, hotel chains) are particularly vulnerable.
While fiscal policy can help overcome such disadvantages, it must be remembered that, while the US dollar has the luxury of being the world’s reserve currency, the US cannot continue to borrow at the current pace in its attempt to prop up an overly indebted government and corporate sector.
The starting point counts. The US government was already running a sizable budget deficit. This, twinned with a trade and current account deficit, makes the US dollar vulnerable to investors switching their asset allocation away from the US to the rest of the world.
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