This article is written by Giles Coghlan, Chief Currency Analyst at HYCM
In recent months we’ve seen the US dollar index (DXY), which tracks the US dollar’s performance against a basket of six other currencies, surging to its highest levels since 2017. This last move higher occurred in tandem with the spreading of the coronavirus across the globe. However, the dollar’s upward path was already well underway even before the virus became the main talking point. Between February and July of 2018, the DXY surged by over 8%. Since January of this year, it has pushed higher by a further 3%, with it being up almost 6% at its highs in late March. But what is causing this strength and what does it mean for the global economy?
QE to QT
Between 2015 and 2018, the US Federal Reserve enacted a quantitative tightening program in order to reverse the quantitative easing that had caused its balance sheet to balloon from $925 billion in 2008 to $4.5 trillion in 2017. In 2017, the Fed began to wind-down, or “normalise,” which involved gradually paying off the debt it had issued without issuing new bonds, effectively reducing its balance sheet as well as the supply of money in the banking system. It had already begun tentatively raising interest rates in 2015 when it hiked for the first time since 2008. It rose once more in 2016 and would continue to hike a further seven times over the following three years, taking the Fed funds rate from 0.50% in 2016 to 2.25% by the end of 2018.
The Fed’s tightening caused a shortage of dollars along with a massive influx of capital into the US. This took place as investors from all over the globe ditched their local currencies in favour of the higher yields and outperforming stock market of the United States. The trend was intensified by President Trump’s tax reforms at the end of 2017, which led to a repatriation of dollars by US firms and caused asset prices in the country to rise even further. It was also influenced by loose monetary policies and negative interest rates in Europe and Japan that combined cheap money and low growth with the prospects of higher returns in the US.
Foreign-held US dollar debt
At the end of January, the Bank of International Settlements published its global liquidity indicators for the period ending in September of 2019. It showed that US dollar debt held by non-bank borrowers had grown by 5% year-on-year to a total of $12.1 trillion. Of this sum, $3.8 trillion was held in emerging markets and developing economies. It’s important to keep in mind that the global economy was already slowing well before the impacts of the coronavirus began to be felt. Emerging markets had been rattled by the implications of the US-China trade war. The MSCI Emerging Markets Index showed some growth for 2019, but it was sluggish, failing to even approach the highs of 2018.
Then the unthinkable occurred early this year as rumours of a global pandemic spread only marginally faster than the virus itself. Markets were sent into a tailspin and everyone began selling all that they could in order to get their hands on as many US dollars as possible. At its lows in March, the MSCI Emerging Markets Index touched levels last seen in 2016 as investors rushed to pull capital out of these markets. The massive amount of outstanding US dollar debt, capital flight, and a global slowdown that has suddenly come to a juddering halt means that there are not enough dollars to service these debts, let alone to pay them back. As businesses outside of the US scramble to raise dollars in order to pay their creditors and suppliers, the problem only gets worse.
The flight to safety
Aside from all the outstanding US dollar debt, the biggest difference between a slowing global economy and one that has had its legs cut out from under it, is widespread fear leading to panic. The coronavirus crisis has caused a flight from almost all assets that investors would have been happy to hold if we were still merely in a climate of slowing growth. Value that was held in global stock and commodity markets has recently evaporated as the flight to safety commenced.
By the end of February, it was estimated that $6 trillion was lost from global stock markets within a period of six days. Much of that value has been lost forever, or at least until the next cycle peak, but a lot of that value is now being hoarded in cash, and a lot of that cash is in US dollars. When business as usual draws to a close and all bets are off, all that remains is for companies and individuals to hoard as much cash as they can in an effort to keep themselves afloat until the threat subsides. All plans for the future in the form of investments are deferred and capital is pulled. Cash sits on the sidelines in order to guarantee the survival of some market participants while allowing others to wait and pick up assets on sale at the depths of the crisis.
The outcomes
Apart from making imports cheaper for the United States at the cost of raising the price of its exports, a shortage of dollars has the effect of worsening an already dire situation. The hoarding of dollars further exacerbates both their shortage and the falling prices of other currencies and assets. In a global economy where the greenback is on the other side of almost 90% of all FX transactions, a strong dollar tightens financial conditions, which is why the Fed has scrambled to open up swap lines with other central banks.
The situation is particularly troubling for emerging markets because as their currencies weaken the costs of servicing their debts soar, even the commodities that they could ordinarily sell are also plummeting in the face of stalled demand. Selling at any price in order to secure US dollars only adds to the glut and causes commodity prices to drop even further. We recently witnessed the absolute collapse in the price of the front month contract for West Texas Intermediate, dropping from $18 to $10, then to $0, and eventually plummeting to around -$40 for the first time ever. These are the sort of dislocations you can expect to see with a shuttered global economy that still requires a constant supply of dollars to survive.
So what to expect? It’s now widely accepted that we’re in line to see the largest quarterly declines in global growth since 2008. The big question remains how fast parts of the global economy can start spinning up again and this largely depends on whether the countries that are now starting to loosen their lockdowns can avoid secondary outbreaks. As far as the US dollar goes, even the Fed’s rampant money printing doesn’t seem able to keep up with demand. It’s balance sheet is now way over $6 trillion, which has somewhat dampened the dollar’s rise, but Goldman Sachs seems to believe that the dollar’s “historic rally is not quite over,” stating that it expects a further 3-5% rally in the trade-weighted dollar index, assuming that there’s further decline in equities. Further declines do seem likely at this point. As we’ve seen recently in the oil market, the domino effects of this coronavirus crisis are only starting to become clear, which makes the case for holding dollars all the more persuasive at this time. There will be opportunities to come, but for now we’re still waiting for the dust to settle.
