U.S. Dollar in the inflation storm
The dollar’s share as a reserve currency among the world’s central banks has decreased over the past 25 years. Statistics from the International Monetary Fund (IMF) show this development each year, so the dollar now accounts for around 60 pct. of the total reserves, which is the lowest in 25 years. This seems to be one of the arguments supporting the view that the dollar is finally losing ground, but the truth is that 20 years ago, the dollar made up approximately 70 pct. of the total central bank reserves. This confirms that the change in the reserves is, in fact, a very slow movement, which affects the exchange rates in a limited way, and wherein the signal concerning the change is not very significant either.
Another way to relativize the argument using the dollar as a declining reserve currency is to compare it with private wealth. Our own latest calculation of the total global reserves at the central banks shows approximately USD 15,000 billion in reserves, which is a considerable sum. But if one includes the estimates from the annual report “The global wealth report” from major Swiss bank Credit Suisse, the growth in global wealth alone in 2019 was USD 36,000 billion. 2019 was a sunny year for investors, though the figure just expresses the change in global wealth, which must be compared to the central banks’ total reserves. I argue that investor investment flows have much bigger short-term and long-term importance. I cite this relativization because I have a reservation towards some arguments used in the current discussion concerning where the dollar is heading for the rest of the year, such as the argument on the change in the central bank reserves.
The market discussion surfaces due to the fast-rising inflation that has now reached 4.2 pct. in the USA (graph one). Surely, high inflation is a threat to a stable currency, and an economy with a higher inflation will normally have a currency that depreciates equal to the inflation difference compared to other countries. Yet, the inflation is on the rise across the world, which makes it hard to claim that one certain economy, or currency, is particularly in danger due to the high inflation. Therefore, this development does not immediately cause me to change my view on the dollar. Graph two shows the development of the dollar against a basket of currencies where one can observe that the dollar has lost four to five pct. during the time with the Covid-19 pandemic, however, I assess the movement as within normal fluctuations.
Part of the current concern about the dollar is based on very long-term developments, like the example with the central bank reserves. These long-term forces won’t provide investors insight about the direction of the dollar for the rest of the year, nor will any difference in inflation around the globe result in any big movements between the major currencies this year. If a direction will be set for the dollar in the coming second half of this year, I expect it to be caused by other forces.
The global currency market has a dysfunctional element because the Chinese renminbi isn’t free-floating. With a weak economy and partially negative interest rates in the Eurozone, combined with growing concern about the outlook for the American economy, then a normal market reaction would have been a capital flow towards China. Especially during the past 3 weeks, this capital flow has taken place, bringing the renminbi to a three-year high towards the US dollar. In a free-floating market, I am convinced that the movement would have been much bigger, but due to this technical reason (the non-free-floating renminbi) the foreign exchange markets remain quite stable.
A fair share of investors is probably considering a partial allocation away from the dollar. But the euro is far from being the most attractive destination, which generates a blocked situation, which again partly explains why no new long-term trends are established in the foreign exchange market.
Looking at fundamental reasons for a currency to move, then an extraordinarily strong crisis or fear traditionally moves investors, but these two factors do not necessarily lead to the same market reactions. In a strong crisis (war, catastrophe with global reach, heavy terror etc.) investors, companies, etc., will typically increase their cash holding and therefore off-load financial assets. In such situations, indebted countries will most likely feel the pressure. Since the United States has developed into a giant debtor nation, one should not be surprised if the dollar decreases in value during a global crisis.
It is not impossible that some investors are concerned about a really strong crisis, while other investors have greater fears in the financial markets, leading to higher uncertainty and therefore seeking out a safe haven. Since the renminbi isn’t available like the US dollar, then the dollar still serves as a short-term safe haven for some investors. As mentioned, I argue that the two forces (strong crisis and fear) balance each other out, although intuitively, it does not seem logical. Another factor in favour of the dollar is the higher interest rate level in the US, especially compared to the euro and the Eurozone.
I have no doubt that under normal circumstances, new long-term trends would have been established in the foreign exchange market a long time ago, but “normal” has been put out of play. Therefore, my overall assessment is still quite undramatic, where a minor weakening of the dollar is an option, but my primary scenario for the rest of this year remains relatively modest, with a forecast of continued limited fluctuations for the dollar.
