Dollar builds another head of steam
Confounding consensus yet again, the dollar is building another head of steam – a jarring prospect for those who see that as a harbinger of financial stress as well as an aggravator of it.
Even though speculative bets on a weaker dollar were pruned in June, and the collective size of that punt is a third of what it was in January, there remains a substantial net short position against the greenback – one that’s persisted right through the pandemic.
Forecasters in Reuters’ latest polls, on average, continue to see further dollar weakness into yearend.
But the dollar won’t lie down.
It bamboozled most currency experts with a surge during the first quarter. And while some of the heat came out of that subsequently, it’s back at its highest since early April against most major peers – the pound, euro, yen and Swiss franc.
On one level, it shouldn’t be a great surprise. Few doubt the Federal Reserve is turning more hawkish while the others G7 central banks are pointedly not. And the Fed may well signal some reduction of its money printing over the next 3 months.
A worrying new wave of COVID-19 variants in Europe and across Asia could delay lifting of travel restrictions at least there and stall a much-touted broadening of the post-pandemic recovery beyond the United States.
And Transatlantic real, or inflation-adjusted, yield spreads have moved more supportive of the dollar again in recent weeks.
Even in the realm of political risk, the third quarter may pack more of punch for the euro as Germany heads to the polls in September, the pound grapples with thorny Brexit realities and the yuan braces for more U.S.-China tensions.
So why the puzzlement and continued bearish bets?
For asset managers, the persistent ebbs and flows of the pandemic won’t prevent its eventual vaccine-led end. As the world recovers, many assume investors already concentrated in tech-heavy U.S. equities or Treasury bonds will eventually seek more value elsewhere.
For those reasons, Lombard Odier’s Chief Investment Officer Stephane Monier puts “moderate” depreciation of what he sees as a 20% overvalued dollar as one of top 10 “convictions” for the second half – albeit with caveats about an even more hawkish Fed or harsher waves of COVID.
If so, renewed dollar strength may be just fleeting and connected midyear calendar adjustments or even just trepidation ahead of this week’s June employment report on Friday.
But are other things brewing in the background.
Some analysts are starting to look at the fallout from the overwhelming flood of cash in U.S. money markets – due a combination of zero Fed policy rates, ongoing bond buying and U.S. Treasury running down its outsize general account (TGA) at the Fed to under $500 billion by August.
The rundown of the TGA from more than $1.7 trillion late last year has temporarily replaced new Treasury bill sales as a way to fund pandemic relief and fiscal stimuli because of an Aug. 1 deadline on extending the Federal debt ceiling.
But its rundown, which has at least $220 billion to go this month, mechanically increases commercial bank reserves at the Fed, while leaving a dearth of T-bills to park the excess cash in and flooring those bill rates to zero in the process.
The Fed has tried to mop up all this extra cash through so-called overnight reverse repo operations – and increased the interest rate on these to 0.05% recently to help do so. But the result has been daily volumes this week hitting records of close to a trillion dollars.
Whether this is seen as Fed tightening per se or just a reflection of sheer scale of money sloshing around the system is a moot point. If the TGA rundown slows after this month and T-bill sales increase instead, it may take all the pressure off.
Saxo Bank’s John Hardy points out the problem hasn’t changed futures pricing of future Fed policy rate rises per se. But he said it could be “driving the belief that the Fed will have no choice but to taper asset purchases sooner rather than later.”
If that were the case, a technical money market problem could have a more durable dollar impact than first thought.
But should we care if the dollar continues rising?
Right now, it doesn’t appear to be a stressful move akin to the scramble for dollar funding around the world as the pandemic unfolded last year.
Soaring premia on dollar funds back then, reflected in so-called cross-currency basis swaps, haven’t resurfaced yet – thanks in part to swap channels between the world’s main central banks.
But for countries and banking systems with big dollar debts, rising U.S. real rates and a higher dollar exchange rate can still be toxic by tightening financial conditions considerably – feeding dollar demand in the process in a dangerous loop.
While a higher dollar may be welcome in advanced economies in Europe and Japan, it’s a financial squeeze for emerging markets more dependent on overseas funds.
The Bank for International Settlements annual report warned again about this, adding many emerging markets are running large fiscal deficits, external debt ratios have increased and credit ratings have deteriorated.
“Historically, these vulnerabilities have coincided with greater investor retrenchments.”
Source: Reuters (Mike Dolan; editing by David Evans)