In last week’s Week Ahead publication, we presented an argument against the runaway inflation side of USD debasement. This week, we will look at the reserve status of the USD debasement narrative. Put simply, the USD’s dominant reserve currency status is unlikely to change anytime soon. However, the question on what it would take to precipitate a change is an interesting one.
As the center of the international monetary system, the US enjoys “exorbitant privilege.” This privilege allows the US to run up larger debts that effectively gives it looser budget constraints than other countries. Ultimately, there are 4 key determinants for being a dominant global currency: economic and trade patterns, financial market depth, confidence in the value of the currency, and inertia.
On all these dimensions, the USD remains far ahead. The US remains the largest economy in the world. In terms of financial markets, there isn’t another bond market that can match the depth and liquidity of the US Treasury market especially during times of crisis. With regards to inertia, there has been only one change in the dominant reserve currency since the 1800s when the world went from the GBP to the USD after World War II. Notably, the GBP remained the preferred global currency for decades after the US became the largest economy and largest exporter in the world, illustrating the impact of inertia.
This isn’t to say the USD can’t be replaced. Assuming it does, it is more likely due to internal threats than external ones. The Chinese yuan has been raised as a possible alternative given that China is the second largest economy, but the yuan is a distant competitor at best. An argument can be made that the CNY isn’t even a competitor as the currency remains an instrument of the Chinese government, making it a poor store of value. Even ignoring this, the yuan suffers from a lack of financial depth. The Chinese bond market can’t compare to the US Treasury market and CNY turnover in the FX markets pales in comparison to that of the USD and EUR. As for the euro, it is difficult to see it as a credible alternative due to the lack of a fiscal and banking union.
This leaves internal threats, such as fiscal or monetary policy mistakes, as the most plausible ones. On the fiscal side, undermining the Treasury markets would undermine the USD’s reserve currency status. Such an event nearly happened in 2011 during the debt ceiling crisis. On the monetary policy side, a loss of Fed credibility is at risk. This could come through unexpectedly high inflation but that appears unlikely. A bigger danger appears to be a loss of credibility due to Fed appointments that indicate Fed independence has been eliminated.
Of course, this isn’t a binomial game. It is possible that the world moves to a multipolar currency world over the very long term. For scale, it has taken over two decades for the USD’s share of central bank reserves to go down 10%. This all nets out to the USD not being replaced anytime soon.
The Fed’s shift in how it looks at inflation and employment solidified the “lower for longer” narrative as the Fed will be more tolerant of inflation overshoots. The ECB is also going through a policy review. Arguably, the Fed’s decision could make it easier for the ECB to adopt a similar shift on inflation. On a more macro level, the overall picture remains unchanged with EURUSD supported by optimism on the euro and pressure on the USD. With recent drivers of USD weakness—Congressional gridlock, high absolute COVID levels etc.—still in place, further USD pressure is expected to continue. Given this, COVID infection curves are starting to converge between the US and Europe and positive economic surprises in Europe have started to pull back. Expect further consolidation.
This past week, cable moved higher to levels not seen since the December 2019 UK elections. The view remains that GBPUSD’s bid is a reflection of USD weakness with a pullback in market expectations for negative BoE rates also helping. Regarding the USD, Fed Chair Powell was clear in the Fed’s dovish position. On the UK side, focus will be on restarting schools, the UK economy and making progress on Brexit talks. COVID infections in the UK have begun to rise again and risks stalling what has already been a relatively slower recovery. With not much change to the overall picture, the expectation remains for cable to continue to range trade with the USD side most likely to provide the catalyst for any move outside this range.
PM Abe’s resignation was last week’s key development. While Abe’s resignation garnered many headlines, fiscal and monetary policy is unlikely to materially change under Abe’s successor. Keep in mind that Abe resigned due to health and not economic reasons. As a result, the overall picture remains unchanged. USDJPY has been more closely correlated with yield differentials than other currencies and this should continue. Additionally, US fiscal uncertainty should play a factor. On the JPY side, real rates continue to support yen strength and a pullback in outbound investments reduces a source of idiosyncratic yen weakness. USDJPY has been range bound since April and this should continue with a bias for JPY strength.
USDCAD strengthened against the USD this past week but weakened against all other G10 currencies except the yen. This implies that USDCAD appreciation is more of a USD weakness story than one of CAD strength. The CAD’s underperformance against its G10 peers (ex. USD) reflects Canada’s unique vulnerabilities to the COVID shock that can be seen through Canada’s poor balance of payment position. As an example, the recent bounce in oil prices has not benefited Canada’s trade account as the rise in oil prices is driven by production cuts, especially from high cost producers such as Canada. Persistent USD weakness makes further USDCAD gains possible, but the bias would be to fade CAD strength. Canada’s jobs report will be this week’s key economic release.
Headlines around US-China tension continue to come out, but ultimately, the markets are viewing the recent actions/rhetoric from both sides as largely symbolic. A strong balance of payments position and ongoing USD weakness form the base for a stronger CNY. Capital inflows, especially on the bond side, have been strong and are expected to be persistent as the global search of yield continues. These inflows should receive a boost should Chinese bonds gain inclusion in another bond index at the FTSE’s inclusion review in September. Longer term, geopolitics remain a concern especially as we get closer to the US election, but for now, expect the yuan to be supported.
The Aussie’s correlation to risk markets has help AUDUSD continue to move higher. As with other currencies, USD weakness has played a large role in recent price action. Additionally, higher iron ore prices and CNY gains have helped with sentiment and has AUDUSD currently around levels not seen since the summer of 2018. On the negative side, weak growth and potential tensions with China (both US-China and Aussie-China) linger. Additionally, global economies are transitioning from “easy” growth to a more difficult path as the initial re-opening bounce has passed. The AUD likely remains supported but it’s difficult to get too excited about a move higher given the AUD’s elevated level and rising infection numbers domestically. The RBA meets this week and should be on hold.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
US ISM Manufacturing PMI
Expectations for a 54.5 print
US ADP Employment Report
Expectations for a 900K print
US Initial Jobless Claims
Expectations for a 950K print
US Non-farm Payroll Report
Expectations for a 1.5 million print
Canadian Jobs Report
Expectations for a 250K print
EZ CPI YoY
Expectations for a 0.2% increase
EZ Unemployment Rate
Expectations for an increase to 8.0% from 7.8%
EZ Retail Sales MoM
Expectations for a 1.4% increase
German Unemployment Rate
Expectations for the rate to remain unchanged at 6.4%
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