On March 19, in its most significant intervention of the Covid-19 crisis, the Federal Reserve extended dollar swap lines to include 14 foreign central banks, supplying essentially unlimited dollar financing globally.
The acute scramble for dollar financing that caused a 7 per cent appreciation in the eight days running up to March 20 reversed as funding conditions eased.
Among currency traders, where analysis often extends to “the trend is your friend”, dollar weakness has become a consensual position.
There are solid arguments supporting short-term dollar weakness, most notably that US interest rates have reduced significantly relative to other developed markets in 2020.
It is also argued that the Fed’s increasing interventionism caps dollar appreciation; given an unlimited supply of dollars from the Fed in every crisis, there must be other more attractive safe haven options out there.
Key Points
- The dollar has depreciated substantially since March 20
- The Federal Reserve has been increasing its intervention in the currency
- The euro should be the strongest candidate for appreciation
- Japan still has a huge debt
These arguments hold some weight in the short term but would be more powerful if it were clearer which other currencies were likely to structurally appreciate over the longer term.
The dollar holds a central role in global trade and financial architecture. In 2019, 90 per cent of all currency trades had the dollar on one side. Within global currency reserve holdings the dollar makes up 60 per cent, the euro 20 per cent and the yen 6 per cent (with 14 per cent made up of a basket of lesser currencies).
Global intervention by the Fed may cap the dollar’s upside, but it also reinforces the Fed as the world’s central bank and the dollar as its reserve and trading currency.
During the Covid-19 crisis other central banks were relegated to satellite distribution hubs, administering the Fed’s dollar swap programme.
In theory the euro should be the strongest candidate for appreciation.
For a decade the eurozone has run vast positive trade and current account balances. Northern European manufacturers remain very competitive at prevailing exchange rates, underpinning a vast export machine.
However, the euro faces existential challenges due to its ramshackle institutional underpinnings.
At the same time the Fed was supporting the global economy by supplying dollars, the European Central Bank’s modest historic quantitative easing programme was being ruled illegal by the German constitutional court.
As Covid-19 struck at the heart of the vulnerable Italian economy, EU politicians were arguing about the balance of loans and grants in an underpowered EU recovery plan.
The history of currencies that are not backed by a coherent sovereign state make us wary of assuming structural appreciation of the euro.
Japan meets all the criteria of a coherent sovereign state, making the yen another obvious candidate. Since the mid 1980s Japan has run trade surpluses, which would be a supportive factor had the balance not recently tipped into a trade deficit.
That said, having amassed huge overseas asset holdings, Japan will run a current account surplus for the foreseeable future. It is Japan’s fiscal situation that looks terrifying.
It has the highest gross debt to GDP ratio in the world (more than 250 per cent) and it continues to run huge deficits with no credible plan to control spending.
The stabilising factors are the huge pool of domestic savers willing to fund the government and an interventionist central bank.
Real yields in Japan are now higher than those in the US. So, while the yen may not look like an appealing currency in conventional terms, it does hold some relative attractions to sovereign bond investors at this time.
We have been increasing CG’s real return fund’s exposure to the yen from a very low base. Other additions have been small increases in the Swedish krona and the Australian dollar.
That said, barring an extreme appreciation in the US dollar, it is hard to see it being displaced from its anchoring position in our fund, much as it is difficult to see the dollar being displaced from its dominant position in the global economic and financial system.
Alastair Laing is chief executive of CG Asset Management
