Dollar Headwinds

by Sean Tweedie | May 29, 2020

The global economy has fallen in a very deep recession. With so many countries under lockdown economic activity has come to a virtual standstill. The economic cost of saving lives has been significant. The International Monetary Fund (IMF) expects global growth to contract by 3% this year. This is significant when you compare this to 2009 (Great Financial Crisis) where global GDP hardly contracted at all. Despite this, as with other pandemics and crisis’, the global economy will survive. Last month we touched on various measures (both fiscal and monetary) that are being implemented by governments and Central Banks to curb the negative impact of the pandemic on the economy. As a result, currency markets continue to fight a ‘tug-of-war’ between deteriorating global growth on the one hand, and much easier financial conditions (for example, lower interest rates) on the other hand. At this juncture, we may try and place our bets on who we think the likely winners. One of the most powerful drivers of currencies is the relative rate of return between any two economies. After all, an exchange rate is simply a measure of relative prices between any two countries. Currencies act as an equilibrating mechanism and will fluctuate to equalize rates of returns across borders.

It is no secret that the Dollar has been the star of the show for quite some time. Recent Treasury International Capital (TIC) data shows that inflows into U.S. assets have been re-accelerating. The momentum in the purchases of Dollars has been driven by equities as U.S stocks have outperformed their peers. The 2017 change in the U.S. tax code that allowed for the favorable repatriation of capital into the U.S. is still benefiting the Dollar with $192 billion in net assets (close to 1% of GDP) making its way back home. See figure 1.

The demand for the Greenback has been further supercharged by the global shortage of Dollars. The shortage in Dollars was brought about by the Federal Reserve tapering their asset purchases. The Federal Reserve’s balance sheet stood at around $4.5 trillion in 2015, and until recently has been falling. The Federal Reserve allowed for their balance sheet to shrink, by not reinvesting assets as they matured. This triggered a severe contraction in the U.S. monetary base. See Figure 2.

In response to the shortage of Dollars, the Federal Reserve injected massive amounts of liquidity into the system through the process of Quantitative Easing and introduced new swap lines. See Figure 3.


Despite more Dollar liquidity being available to banking entities, much of the offshore Dollar funding has been financed by non-bank entities who do not have or have very limited access to Central Bank swap lines. A rising Dollar not only lifts debt burdens of borrowers but also raises their solvency risk. 32% of the $12 trillion foreign Dollar debt is held by emerging markets. The Dollar is also a currency that thrives in uncertain times due to its appeal as a safe-haven currency. Considering the above it is easy to see why the Dollar may remain strong in the near term. Only when the crisis ends will the dollar begin to surrender to significant headwinds. These headwinds continue to mount and will eventually exert a powerful deflationary force on the Greenback.

For one, U.S. stocks may not stay as attractive forever. Some market participants expect U.S. profits to keep outperforming which may skew the price of U.S. equities. As U.S. equity prices become expensive, one may see that this capital moves to cheaper markets and thus an outflow out of the U.S which would see a period of Dollar weakness. A second factor that may be bearish for the Dollar is the interest advantage the U.S has lost relative to its developed peers. Against an aggregate of G10 currencies, the dollar currently yields almost 0% in real terms. This has historically led to a softer dollar. The catalyst for outflows out of the U.S could be if the U.S. 10- year Treasury yield hits zero if the Fed were to adopt negative rates.

If this were to happen, new bond investors face the prospect of real losses from either higher yields and / or currency depreciation as the Federal Reserve continues to dilute existing Treasury shareholders. The Dollar is the reserve currency of the world with the trade deficit being settled in Dollars. This has historically been an advantage for the Dollar. Recently however, we are seeing more Central Banks diversifying out of Dollars. The void is being filled by other currencies such as the British Pound, Swiss Franc, and the Japanese Yen. There is also some evidence to suggest that China is beginning to destock their holdings of U.S. Treasury bonds to make room for the internationalization of the Renminbi (RMB). See Figure 4.


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