- As the global reserve currency, dollar tends to weaken during boom times (and vice versa)
- Ongoing global expansion means that USD bear market set to continue
- Escalating problems in Eurodollar markets foreshadow problems in the next downturn
After President Trump unveiled his tax plans, many had predicted that the US dollar would strengthen thanks to the inflationary impact of reducing taxes by $1.5T. According to academic theory, an economy with limited slack and high growth is at the risk of overheating if fiscal stimulus is excessive. This is especially true as crude oil (a significant driver of inflation), continues to make multi-year highs. Given recent weakness in the US dollar, markets clearly did not follow academic theory.
As the global reserve currency, the US dollar tends to depreciate during booms
The main reason the US dollar remains weak is due to the currency’s status as the world’s global reserve currency. In short, the world runs on US dollars. During economic booms, US dollars are cheaply and widely available via offshore lending markets (i.e. the Eurodollar market). As borrowed dollars flood the world, the price of financial assets (including other currencies) tends to appreciate accordingly. We are seeing this today with the euro in particular. As we wrote yesterday, EUR/USD has room to keep climbing thanks to strong Eurozone growth.
Thanks to the ongoing boom, US dollar liquidity remains abundant. Our favorite USD liquidity indicator, gold, has been strengthening throughout 2017 and especially since mid-December. Eurodollar lending rates have also fallen sharply after spiking in late December. The rise and fall of Eurodollar rates (as measured by cross-currency basis points) is shown below. Note that negative rates in the chart below imply higher interest rates on borrowed dollars.
Nothing to see here: 3-month euro cross-currency basis
In a previous commentary, we showed that the Eurodollar market is larger than ever, despite its central role in causing the last global financial crisis. According to the Bank for International Settlements, US dollar liabilities for non-US banks are above crisis-era highs at $9T. As long as the good times continue, borrowed dollars will keep flowing and the currency will keep selling off.
An overview of the USD index is shown below. While we continue to believe that the dollar will keep weakening, weak technicals suggest that dollar bears should wait for a better entry point.
USD index at a short-term bearish extreme
Problems in Eurodollar-land
While heavy dollar lending keeps the currency in check during upswings, the obvious issue with the Eurodollar lending system is that the world runs out of dollars during downturns. This magnifies the ‘flight to safety’ into the currency. As a result, the US dollar tends to appreciate when global growth is falling, even if the crisis first appears in the United States. The dollar shortage became acute during the financial crisis in 2008.
When the downturn comes, we expect to see accelerating problems in Eurodollar markets. A few weeks ago, Eurodollar lending rates (particularly for the euro and the Japanese yen) spiked in a sign that the US dollar shortage was back. Rates only fell after the European Central Bank and the Bank of Japan borrowed $12b from the Fed’s USD swap line. While the recent spike in Eurodollar lending rates is not a good sign, our view at the time was that the issue was most likely to be ignored in a bull market.
This being said, we didn’t expect the ECB or the BoJ to tap into the Fed’s swap line. Most central banks are hesitant to access the facility as the operations are public and may trigger further panic. In the early days of the 2007 financial crisis, the ECB initially resisted the Fed’s proposal to instate USD swap facilities (due to the poor optics of the arrangement as described above). Today, borrowing dollars from the Fed is becoming routine.
The next test will come from emerging markets
With GDP growth accelerating in the US, the Eurozone and Japan, there are few signs of an impending downturn. This is especially the case following strong manufacturing PMIs announced yesterday (particularly for the Eurozone). Thanks to the existing network of USD swap lines with developed market banks, one can even argue that the problem of dollar shortages in the Eurodollar system can be bailed out indefinitely thanks to the generosity of the US Federal Reserve. For now, we'll ignore the obvious long-term issue of substantially increasing money supply following every downturn.
Instead, the real test for the ongoing dollar bear market will come from emerging markets. As pointed out by economists including Victor Shih, China has been borrowing Eurodollars via banks in Hong Kong at a fairly rapid clip. This is because the country is looking to rebuild its US dollar reserves following an economic slowdown between 2014 and 2016. At the time, Chinese households began doubting the currency peg due to the size and low quality of outstanding loans in the banking system. Capital outflows increased sharply as result.
Once China enters another downturn, the country's dollar problem is likely to come into focus. If substantial capital flight returns (depleting the country’s foreign exchange reserves) or if Eurodollar lenders fear the creditworthiness of Chinese counterparts, the dollar shortage problem will resurface. During the last crisis, the Fed notably ignored establishing swap lines with developing country central banks. Whether or not the Fed is willing to bail out them out this time remains to be seen.