Don’t cry for the dollar, yet
It looks bad for the dollar, but looks can be deceiving.
Its sharp decline in the last week has pushed the euro to its highest level in a year and reignited fears that there’s only one place for the dollar to go, and that’s down.
Rhetoric from influential investors like Warren Buffett as well as big foreign buyers of U.S. debt like China and Russia has fed that sense of doom.
Then there’s the yen-like role of the dollar as the funding currency, which is casting a pall over the buck since the longer the Fed keeps a lid on interest rates, the longer the pressure stays on the currency.
Yet the dollar is still the No. 1 currency stashed in reserves around the world, by a long shot. International Monetary Fund data showed the dollar accounting for 65 percent of total allocated reserves in the first quarter.
That means there’s only so far you can push the currency before the self-interest of the world’s savers kicks in to support the buck.
First a little perspective. The dollar’s decline this year mirrors the rise in risky assets like U.S. junk-rated corporate debt that have returned to valuations seen before Lehman Brother’s implosion. Just as credit markets shut down and money poured into safe-haven U.S. Treasuries, the dollar soared as currency investors viewed it as a place to hunker down until the storm passes.
It may still be cloudy, but investors have been confident enough to venture back into riskier territory like emerging markets, which are booming.
That’s meant less money for U.S. assets. Recent data from the U.S. Treasury confirmed as much when it showed net foreign capital outflows of $97.5 billion in July, up from the exit of $56.8 billion in the previous month.
The Fed’s zero-bound interest rate policy has also turned the dollar into a funding currency, where investors borrow in the low yielding dollar and invest in nations that offer juicier returns.
“The dollar is selling off because we have low interest rates. That’s a macro fact,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.
Yet, unlike the Japanese yen, which also served as a funding currency earlier this decade, the dollar, or rather dollar-denominated assets, continues to be sought after by nations with big reserves like China and Japan.
Brown Bothers Harriman notes that China snapped up $21.5 billion of such assets in July while Japan added $19.25 billion. Russia and Brazil, which are also sitting on stockpiles of reserves, trimmed their holdings by a relatively small amount.
This is significant. Earlier this year, China and Russia spooked currency markets when they began talking about the need for an alternative to the dollar for the world’s currency reserves.
Such an alternative would help savers like China better protect the value of their assets should the dollar fall out of favor, as it is now. Yet it could take years if not decades to implement.
That means the dollar is still the only game in town, rightly or wrongly, which should provide some comfort to those fearing the worst — a dollar in freefall without a net.