The dollar is on fire, and when it comes to explaining the now historic surge in the US dollar, where the Bloomberg Dollar index just hit an all time high...
... all one needs to know is what we wrote over the weekend, and repeated today, namely that the world is facing a historic, $12 trillion dollar margin call which won't end until investor confidence is somehow restored.
However, we realize that some traders - probably those who are down 50% or more YTD - will mock our take, and opt for an "established" analysis, like that from -say - Goldman Sachs which three months ago said the economy was nearly "recession-proof."
But don't worry, there's a lot of muppets out there judging by what Goldman's FX strategist Zack Pandl just wrote, noting that virtually everyone wants to know what the hell is going on with the dollar:
Incoming questions from investors are focused on why the Dollar has appreciated against certain crosses—e.g. GBP, NOK, or AUD. We think it is probably more appropriate to consider the factors that are driving USD trends broadly, including the reduction in equity hedges, reserve rebalancing, and global economic weakness.
What we find shocking is that for once "no recession in our lifetime" Goldman actually makes the right conclusion:
In our view, the Dollar is unlikely to weaken substantially against almost any cross (perhaps JPY and CHF excepted) until global markets stabilize.
With that conclusion in mind, here is how Wall Street FX analysts - who tend to be wrong about 80% of the time, just ask Goldman's former FX strategist Thomas Stolper - view the role of the US dollar:
The US economy looks headed for recession, the Fed has slashed policy rates to their practical minimum, and US equities are trading at their lows. Despite all this the Dollar has surged over the last week, reaching new cycle highs on our broad trade-weighted index. Most of the time, rapid currency appreciation reflects the outperformance of one economy compared to its peers—i.e. when there is a strong preference for a country’s goods or assets relative to others. We do not think that is the case today. Instead, recent Dollar gains likely reflect the greenback’s dual role as a domestic currency and an international currency—what we have termed the “two Dollars”. In our view, Dollar appreciation reflects the unique role the currency plays in the global economy and financial system, rather than a view among investors that the US economy is better placed to weather the coronavirus shock.
Translated: the dollar is a global funding currency for $12 trillion in USD-denominated global debt... and the margin call has just come in. But it wouldn't be very cool for Goldman to rip off what we said days ago, so here is what Goldman did say in explaining the three reasons behind the dollar's surge:
Beyond the traditional “safe haven” role of US Treasuries, the Dollar has a number of features which help explain its behavior during economic downturns and periods of extreme market volatility:
- 1. Denominator of US capital markets. The Dollar denominates US equity and bond markets, the world’s largest important capital markets. Because of the large size of US markets, international investors tend to hold many more US assets than domestic investors hold of international assets. This imbalance can have implications for currency markets. For instance, many non-US investors own US equities on an FX-hedged basis. When equity market cap declines they are left with over-sized hedges, and bringing the notional value of hedges down therefore generates USD buying. Because the US market is so large, these flows tend to dominate any USD-selling flows by US investors. Research from the BIS suggests this was one factor behind the Dollar’s appreciation during the Global Financial Crisis. Some of the issues playing out in money markets— especially wide cross-currency basis—reflect similar underlying imbalances.
- 2. Intervention currency. When central banks intervene to defend against excessive depreciation, they most often sell US Dollars to buy their domestic currency. All else equal this slows the Dollar appreciation against that cross. But for the broad Dollar often more important is what comes next: selling USD changes the currency composition of reserve assets, so reserve managers may take rebalancing operations, buying USD vs other reserve currencies like EUR or GBP to replenish supply of the preferred intervention currency. As a result, FX intervention may paradoxically boost the Dollar vs certain G10 crosses.
- 3. Global invoice and lending currency. The Dollar denominates most global commodity trade, most cross-border lending to emerging markets, and an outsized share of global trade volumes (see here for more background). In an economic downturn: (i) commodity prices fall, resulting in lower USD revenues for producers; (ii) trade volumes fall, resulting in lower USD revenues for other exporters, and (iii) cross-border lending dries up, resulting in lower USD assets for borrowers. Exactly how these factors effect FX spot markets is a source of debate. But, in our view, they may create Dollar scarcity in some parts of the global economy, resulting in selling of non-USD assets to accumulate USD balances.
Said simply: the USD is the world's reserve currency, which while a huge benefit to the US when times are good, is an unbearable burden during crashes such as this one. While there is no simple solution, the legendary inventor of the MOVE index did propose a brilliant solution back in 2016: the Fed can always crush the dollar by buying gold in the open market, effecting another FDR-like devaluation of the dollar. Because as J.P.Morgan famously said in 1912 "Money is gold, nothing else." One year later the Fed was born.