USD Is Ugly But Not Hideous: Has It Lost Its Allure?
The combination of an expanding Fed balance sheet (effectively debasing the USD) and unresolved fiscal/debt issues (recall the debt ceiling debacle and ratings downgrade) has resulted in plenty of foreign criticism of US policy but also has raised fears about the USD’s value.
Diversification and the dollar:
FX diversification has been ongoing and the USD share of FX reserves has steadily declined but remains relatively high relative to other countries.
EUR share has actually decreased recently as worries about a break up of the Eurozone have intensified.
The share of reserves into ‘other’ currencies has increased sharply over recent months, surpassing GBP and JPY. ‘Others’ includes AUD, RMB etc.
While such flows are a long way off from threatening the superiority of the USD the trend is clearly in place for a longer term shift towards broadening the range of reserve currencies.
USD is losing its reserve currency status…
More and more countries are shifting away from the USD. BRIC countries in particular are accelerating bilateral trade and swap agreements to bypass the USD.
However, there is a very long way to go before this poses any threat to the USD’s dominance.
Treasury buying has been a big support factor for USD…
Foreign portfolio inflows into US Treasuries have been the most important source of funding for the US current account deficit.
Foreign investors have channeled over $750 billion into US Treasuries since 2011, which amounts to around 5x the inflow into US agencies and almost 10 x the inflow into US equities.
...But Asian demand for Treasuries is waning
Foreign investors hold around 51% of US government debt, with China the largest holder followed by Japan. A drop in inflows would lead to an acceleration in the decline in the USD.
It is not easy for central banks to act on their concerns. China is faced with a ‘USD trap’ in that any decline in their buying of US Treasuries would reduce the value of existing Treasury holdings.
QE3 largely priced in
While we would not overplay the risks to the USD, at the least QE3 will act as a small restraint on the currency. However, we believe a lot is priced in.
USD will outperform from a growth perspective
Policy makers are acting to stem the crisis but it does not mean that growth will bounce back quickly, but merely that it will at least help to avoid a catastrophe in Europe.
The US economy is set to outperform relative to the other major economies although growth will remain below trend and risks remain from a lack of resolution to the fiscal cliff.