Looking Beyond the “USD Smile”

In the following analysis, I will delve beyond the concept of the 'USD smile' and evaluate the influence of various drivers that have diminished the attractiveness of the USD in recent weeks:

De-dollarisation;The US debt ceiling; andA USD economic downturn

De-dollarisation could be a long, multi-year process…

Since the implementation of sanctions by the Western nations against Russia following its invasion of Ukraine, foreign exchange (FX) investors have been engaged in speculation. They believe that the widespread usage of the US dollar (USD) to enforce and amplify the impact of US international sanctions would eventually lead emerging market (EM) central banks to gradually reduce their holdings of the USD. The trend among several EM economies to settle bilateral trade in their own currencies has intensified concerns regarding the USD's status as a reserve currency. Many FX investors anticipate a potential scenario in which the global economy becomes multipolar, characterized by competing trade blocs that employ different reserve currencies. In this scenario, the USD, along with the Euro (EUR), Japanese yen (JPY), and British pound (GBP), could potentially be surpassed by the Chinese yuan (CNY).

The concerns surrounding de-dollarization have been further intensified by the significant decline in the USD's share of global central bank reserves, as indicated by the IMF COFER data (Figure 2). In fact, based on the latest data from Q422, the USD's share has reached its lowest level since 1995. It is important to note that, despite this decline, the current USD-share stands at approximately 58%, significantly higher than the lows of around 45% observed in 1989, just before the dissolution of the Soviet Union and its trade bloc with Eastern Europe. The USD's share in foreign exchange (FX) reserves experienced a remarkable growth after that period, driven by the currency's dominance in global trade and financial transactions, which fuelled demand from central banks.

However, this upward trend came to a halt around 2000 with the introduction of the Euro (EUR), marking a reversal in the USD's share. More recently, the decline in the USD's share has accelerated following the SDR (Special Drawing Rights) reform in 2016, which led to a rapid increase in the Chinese yuan (CNY) share in FX reserves.

Nevertheless, I hold the view that the forces driving de-dollarization may require an extended period to exert a significant influence. This perspective is supported by the most recent COFER data, which clearly demonstrates that the USD's share comfortably surpasses the combined share of its seven most liquid alternatives (Figures 3 and 4). This observation underscores the continued dominant position of the USD in global trade and financial transactions, as well as the fact that a substantial portion of financial securities are denominated in USD.Fig 3. USD and EUR share in central bank FX reservesSource: Bloomberg, IMF COFER, CIB

Fig 4. Other major currencies’ shares in FX reservesSource: Bloomberg, IMF COFER, CIB

Fig 5. Currency share in SWIFT paymentsSource: Bloomberg, CIB

Fig 6. USD vs net FDI and equity portfolio inflows into the USSource: Bloomberg, CIB

Furthermore, I anticipate that even in the event of further escalation in recent geopolitical developments, leading to an accelerated shift towards rival trade blocs adopting their own reserve currencies, the potential consequences could be particularly detrimental for proxies of developed economies. Specifically, currencies such as the Euro (EUR), Japanese yen (JPY), British pound (GBP), Australian dollar (AUD), Canadian dollar (CAD), and Swiss franc (CHF) could face significant challenges. This expectation aligns with the latest payment data from SWIFT, which indicates that the USD's share increased primarily at the expense of the EUR and other highly liquid G10 currencies during 2022 and early 2023 (Figure 5). Indeed, it appears that the USD has regained its dominance amid escalating geopolitical tensions between the Western nations and Russia.

…and could be preceded by friendshoring

I anticipate potential positive developments for the USD in the upcoming quarters due to increased capital inflows into the United States because of the phenomenon known as 'friendshoring.' This trend may potentially precede a more enduring shift in foreign exchange reserves of emerging market central banks away from the USD. Recently, both the United States and the European Union have taken measures to establish more dependable supply chains through the practice of 'friendshoring,' which involves relocating the production of essential components to economically friendly nations. The United States took an early lead in this regard when the Biden administration successfully navigated the passage of the 'Chips Act' through the US Congress. This legislation provides financial incentives to encourage companies to expand domestic semiconductor production within the United States.

Can the US debt ceiling be positive for the USD?

The conclusion of the US tax season in April has refocused attention on the US debt ceiling. Considering apparent tax revenue shortfalls, foreign exchange (FX) investors have revised their projections for the 'date-x' when the US Treasury might exhaust its resources to meet financial obligations. Anecdotal evidence indicates that the latest refund data may accelerate this timeline, bringing it forward from the previously anticipated August-July timeframe to as early as July or even June. The recent increase in the yield of 3-month Treasury bills further indicates mounting market uncertainty, particularly as Democrats and Republicans remain at odds regarding a potential resolution. The latter party advocates for additional fiscal austerity measures as a condition for a bipartisan debt ceiling agreement. While I maintain my expectation that a compromise will eventually be reached, I am concerned that it may entail further negotiations and the possibility of a government shutdown, both of which could intensify political uncertainty and market volatility. Additionally, it is worth noting that the risk of a US recession in the second half of 2023 could amplify market risk aversion.

A US downturn to fuel volatility, in a boost for USD

Leading US economists are anticipating a moderate recession in the second half of 2023 (H223). If this projection materializes, the recession would commence shortly after the Federal Reserve concludes its tightening cycle, likely in May. This scenario deviates from previous instances of US economic contractions, which typically manifested a full year following a pause in Fed actions. Furthermore, historical patterns have shown that the extended intervals between past peaks in Fed tightening and US recessions were accompanied by diminishing inflation and deteriorating economic indicators. Consequently, the Fed shifted its focus from raising rates to combat inflation to lowering rates to support the economy. In contrast, I believe that during this forthcoming recession, the US labour market will exhibit resilience, leading to wage growth and thereby sustaining elevated services inflation. Consequently, I anticipate that US inflation will persist uncomfortably high throughout the economic downturn, prompting the Fed to maintain interest rates at their current level for the entirety of H223.

This content may have been written by a third party. ACY makes no representation or warranty and assumes no liability as to the accuracy or completeness of the information provided, nor any loss arising from any investment based on a recommendation, forecast or other information supplied by any third-party. This content is information only, and does not constitute financial, investment or other advice on which you can rely.