A U.S. dollar drought that’s defined the financial stress of coronavirus is being met with a dam burst of liquidity from the U.S. Federal Reserve. The resulting flood of dollars could sink the greenback over the coming years as economies normalize.
While funding stress will likely remain high as virus-stricken investors and companies around the world scramble to secure dollar funding, some strategists and a growing body of speculators are betting that the Fed’s intervention could eventually reverse two years of exchange rate gains.
According to Friday’s data from the Commodity Futures Trading Commission, hedge funds and other players built a net short U.S. dollar position against major and emerging market currencies alike to its highest since May, 2018 – showing a powerful countertrade to the recent trend of dollar strength.
And for some senior strategists such as Andreas Steno Larsen at Nordic banking giant Nordea, that’s no short-term punt. The Fed’s action to hose the world with U.S. dollars will have big exchange-rate implications once the panic-driven demand subsides.
“Everyone with a need of dollars will get it in size and this should prove to be a game changer for the dollar, once we are out of this mess,” he said in a research note, adding the greenback could face a hit of more than 15 per cent over the coming 12 to 24 months once the global economy stabilizes.
“A new weak dollar cycle could be on the cards over the coming 2-3 years,” he added, with potentially big tailwinds for commodities and non-U.S. equity.
That view is far from where the market sees the coming months at least. More than two-thirds of 63 strategists polled by Reuters last week said they expected the U.S. dollar to retain recent gains or rise further over the next three months.
But Mr. Steno Larsen argues the Fed is on course to have more than doubled its balance sheet by the end of this quarter, and will by the end of the year expand it to almost a fifth of GDP, or twice the European Central Bank’s equivalent. This will be a significant net negative for the dollar if or when funding pressures dissipate by midyear.
For two years, the world economy has been sapped by a slowly rising greenback – spurred by relatively higher U.S. interest rates and a protectionist push in Washington that led to a trade war and sizable repatriation of U.S. multinationals’ cash piles.
White House resistance to the stronger dollar was vocal and routine, often blaming the Fed for keeping rates too high and lambasting U.S. trading partners for artificially subduing their currencies for trade gain. The Fed, as always, insists it has no target for the exchange rate and only looks to keep inflation in check and sustain employment.
But a rising dollar tightens financial conditions globally because of vast amounts of dollar debt in the world. Dollar credit to non-banking entities outside the United States hit US$11.5-trillion last year – or 13 per cent of annual world output, according to the Bank for International Settlements.
A higher dollar has also been a burn for many countries, especially in developing economies heavily borrowed in dollars.
As a sudden stop in economic activity in response to the coronavirus led many companies and investors to scramble for cash, many measures of dollar funding, such as cross-currency basis swaps, skyrocketed to levels not seen since 2008’s crash.
That was the large and widening dollar hole worldwide that the Fed rushed to fill as it increased standing dollar swap lines with five other big central banks and extended new lines to nine mainly emerging central banks.
Last Tuesday, it also broadened its securities repurchase agreements with foreign central banks, allowing them to exchange holdings of U.S. Treasury securities for overnight dollar loans, a move mostly aimed at stressed emerging market central banks.
The combination of an opening of these dollar taps, a return of interest rates to zero and a relaunch of the quantitative easing program has in just three weeks has seen the Fed’s balance sheet balloon to US$5.86-trillion, and it is rising.
Although banks’ dollar funding costs remain elevated, the Fed’s moves have successfully flattened and even reversed the spike in cross-currency basis swap rates.
The speed with which the Fed can and will want to unwind these emergency moves may dictate the eventual outcome. But the scale of the hit to world output being forecast for 2020 as a whole means it will be in no rush to jam on the brakes, and it will get no thanks from Treasury for any moves to lift the dollar.
“There is so much fiscal stimulus under way globally, we can’t see that outsized U.S. fiscal stimulus will be a clear dollar positive – especially while the Fed is printing money so aggressively,” ING global markets head Chris Turner and team told clients this week. “The dollar’s gains will not last, but [we] need to see financial conditions firm first.”
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