The dollar’s rampage continues into another session today in FX markets, focusing on the G10 currencies that previously performed well amidst the market turmoil; EUR, JPY and CHF. All of the aforementioned currencies have dropped over a percentage point today, with EUR and JPY both testing to close the session 2 percentage points lower today.
The question over what has caused the period of dollar strength to be so relentless over the past few weeks has been brought up time and time again. Even the increased liquidity measures have failed to stem dollar demand, although arguably it has calmed the greenback rally at the margin today.
Arguably, the increased swap lines will alleviate some of the demand for USD in markets, especially as they get extended out to EM economies such as Mexico, South Korea and Brazil where debt denominated in USD ranges from 10-30% when aggregating both corporate and sovereign Eurobonds.
This should alleviate some of the financing demand for USD stemming from emerging markets as debt servicing costs drive higher from the plummet in their domestic currencies. However, further USD funding pressures may come from the EM space as monetary authorities could potentially rebalance their reserves used for smoothing FX volatility, although this is likely to be back-loaded for when the price of the greenback subdues.
The reserve status of the USD and its position as the foundation in the largest markets in the world has arguably exacerbated both the demand for USD and the corresponding market sell-off. Margin requirements are to be paid in USD when equity and commodity markets tank, increasing the demand for USD, while dollar liquidity can also be obtained by liquidating positions in these areas, in turn fueling further selling of assets thus the corresponding margin requirements for the remaining investors.
Arguably, this fueled the vicious cycle in equity and crude markets witnessed over the last week and a half which was set off by the incoming economic shock, while gold markets have also experienced this dynamic despite its haven status in a risk-off environment. Additionally, as mentioned before, the size of USD denominated liabilities globally is staggering, not just in sovereign debt markets but also corporate. At a time when growth grinds to a halt, and USD liquidity dries up due to decreased trade and revenue, the servicing of these liabilities demand more and more dollars in a shorter period of time than would be required in a normal environment.
The above reasoning of why the US dollar is so integral to the global economy and financial system has resulted in the rush for dollars, the safest cash asset. Increased credit and liquidity concerns fuel risk-off sentiment, which in turn prompts a flight to safety in the global reserve currency and an increased need for USD access to pay inflating liabilities. Arguably, the Feds latest measures, which focus on both the domestic and international accessibility to USD funding, represents this.
The expedited nature of the crisis-era programs into action also reflects that lessons have been drawn from 2008 as financial vulnerabilities began to emerge. However, although indicators started to flash red suggesting a credit-crunch could be on the horizon, finding the right ailment to soothe money markets proved more illustrious. In the FX space, swap lines, which have now been extended to all G10 central banks and select EM ones, should take some of the pressure off of basis swaps in the coming sessions, but the lagged nature of this response means most of the damage is done.
The stronger US dollar may be here to stay until the dust settles on the true nature of the economic damage, then growth differentials generated by the stimulus packages released will prove key to determining where the value is to be found in currency markets.
Author: Simon Harvey, FX Market Analyst at Monex Europe.