Two Reasons for One Strong Dollar
Ask anyone on Main Street, and he will tell you there is a dollar shortage. And while the person on the street is talking about his personal need or desire for more money, powerful countries and institutions around the globe have a similar problem.
Take China, for example, whose central bank burned through $330 billion of its foreign exchange reserves this year, just to satisfy demand from Chinese companies and individuals. They have a dollar shortage.
Or the European banks and investors whose shortage is so acute they bid up the dollar 10 percent since its low point at the end of April this year. The euro is now trading at levels not seen since 2003, at an exchange rate of almost 1:1.
Saudi Arabia, also in need of dollars, borrowed $17.5 billion in international bond markets in October to make up for a shortfall in dollar-denominated oil revenue.
So the whole world needs dollars, but there are different reasons why different countries are investing in U.S. assets or borrowing dollars to meet their financing needs.
Some countries have too much of their currency, and it has to decline to reflect the change in supply and demand. Other countries and banks are scrambling to make interest payments in dollars and to repay international debt.
“The rise in Treasury yields makes the U.S. dollar more attractive. It’s a high-yielding bond now versus virtually any other major currency,” Raoul Pal, principal at research firm GMI told RealVisionTV.
Yields on the 10-year U.S. government bond have risen 1.2 percent to 2.55 percent since the low point in July this year.
On the flip side, the European Central Bank and the Bank of Japan have continued buying government bonds, flooding their domestic markets with euros and yen, thus depressing sovereign interest rates to negative. German five-year bonds yield -0.5 percent, while Japanese five-year bonds yield -0.18 percent.
“European money market rates are negative and getting more negative. Nobody wants euros,” said Jeffrey Snider, head of global investment research at Alhambra Investment Partners.
“Is it a dollar shortage or a euro and yen surplus?” said Sean Corrigan, an analyst at Hinde Capital.
“The Chinese have been doing the same since the start of this year. The People’s Bank of China lost dollars, which should be reducing reserves and squeezing the monetary system. On the other side of the balance sheet, they have put in more yuan for domestic use,” says Corrigan.
“They have not allowed the dollar loss to tighten money supply—they have over-loosened. These central banks are providing ample money to buy foreign currency. People are looking around for outlets, and the only high-yielding assets you have in a major currency are in the United States.”
However, some foreign banks are looking for dollars for different reasons. They have to sell high-performing assets like bonds and gold to satisfy margin calls and service their dollar debt.
“They’ve all borrowed dollars,” Raoul Pal told RealVisionTV. “And that offshore dollar market is essentially borrowing dollars from the European banking system, the Japanese banking system, and elsewhere outside of the U.S. banking system. And that’s where there aren’t enough dollars around.”
“If you are a portfolio manager and get a margin call because liquidity is bad, you are going to sell what’s moving,” said Snider. “That’s why you see bond prices fall off a cliff. Very clearly a liquidation event.”
The same is true for gold, which fell $230 per ounce to $1,143 since its recent high in August. “When gold gets hits hard and fast like in 2013, it’s indicative of a global dollar issue,” said Snider.
Snider explains the deleveraging in the offshore dollar market with a shift in bank strategy. After the financial crisis of 2008, banks adjusted their risk appetite, and many closed their proprietary trading divisions in fixed income and commodities.
“Banks are not able to do the same things they used to do,” said Snider. If banks unwind positions in the offshore dollar market, it leads to a reduction in the dollars available in that market. This is called deleveraging.
Another problem has to do with economic growth.
“I’m using rough numbers here: We need $600 billion, $700 billion a year just to make interest payments in dollars,” Brent Johnson, CEO of investment management firm Santiago Capital, told RealVisionTV. “So that’s $600 billion in demand every year for dollars.”
To arrive at the number, he adds up dollar debts in the U.S. banking system, from the U.S. government and foreign entities, and assumes they are all paying the current rate on 10-year Treasury bonds.
If GDP growth is as low as it is—lower than the average interest rate—he says it leads to the dollar shortage we see now.
This deflationary problem is mostly seen in emerging markets. They either have to devalue their currency, like Egypt, or raise interest rates and sell dollar bonds, like Saudi Arabia, to maintain a stable exchange rate to the dollar and obtain enough dollars to service existing obligations.
Saudi Arabia’s currency, the riyal, is pegged to the dollar at a rate of 3.75. However, to keep that rate and compensate for added risk, the interest rate that Saudi banks offer in the interbank market had to rise from 1 percent in 2015 to 2.4 percent at the end of 2016.
Also, because of missing oil revenues, the country had to sell $17.5 billion worth of U.S. dollar bonds to finance government expenditure, a first in the history of the oil exporter.
“If you look at the Saudi domestic money supply, they are in serious deflationary stress at home,” said Corrigan.
Hong Kong, which maintains a peg at around 7.75, had a massive spike in interbank rates to 11.8 percent for overnight loans on Dec. 14.
Egypt, on the other hand, chose the easy way out and devalued the Egyptian pound by 50 percent against the dollar on Nov. 3, because nobody was exchanging dollars for a pound that was too expensive.
And the Fed?
So is the recent Fed rate hike responsible for the dollar crunch? Not really, said Corrigan.
“The Fed is following the market, not leading it. The rest of the world has a pretty strong appetite for dollar assets.”
Snider said a Fed rate hike could add further pressure, “but that’s more so in sentiment than in actual money market rates, especially Asian money markets.”
“China is all about the offshore dollars, and that has nothing to do with monetary policy,” he said.